If you are selling a business, or raising money against its performance, someone is going to do a quality of earnings analysis on your numbers. Understanding what they are looking for lets you prepare, and preparation is worth a great deal more than negotiation later.
The question it answers
An audit asks whether the historical financial statements are fairly presented. Quality of earnings asks something different: of the profit you reported, how much will continue under new ownership?
Those are not the same question, which is why an audited business can still face substantial adjustments. The audit confirmed the numbers were right. Quality of earnings asks whether they are repeatable.
What gets adjusted
Owner remuneration. An owner-manager paying themselves below market rate inflates profit; one paying above market depresses it. The adjustment normalises to what it would cost to employ someone to do that job.
Non-recurring items. A one-off legal settlement, a restructuring cost, a gain on an asset sale, professional fees on an aborted transaction. Removed, because they will not recur. Expect argument in both directions: buyers are enthusiastic about removing one-off gains and sceptical about one-off costs.
Personal or discretionary expenses. Vehicles, travel, family members on the payroll, subscriptions unrelated to the business. Added back, provided they can be evidenced. “Trust me, that was personal” is not an adjustment.
Accounting policy differences. Revenue recognised earlier than the buyer’s policy would allow, capitalisation of costs the buyer would expense, depreciation rates out of line with asset lives.
Run-rate effects. A price increase implemented in month ten, a contract won in month eleven, a cost saving made after the year end. Annualising these is legitimate, and it is also where sellers most often overreach. A run-rate adjustment needs evidence that the change is permanent.
Timing and cut-off. Revenue recognised in the wrong period, accruals released early, provisions that moved conveniently.
Beyond EBITDA
Two areas matter as much as the earnings number and get less attention from sellers.
Working capital. Transactions usually complete on a cash-free, debt-free basis with a normalised working capital target. Setting that target requires understanding the normal working capital cycle, including seasonality. If your working capital is measured at an unrepresentative point, the peg is wrong and you either pay for it or fight about it.
Watch for working capital that has been artificially improved before sale: stretching creditors, chasing debtors harder than usual, running inventory down. Diligence teams look specifically for this, and finding it damages credibility on everything else.
Net debt. Broader than the bank balance. Finance leases, deferred consideration on earlier acquisitions, unpaid tax, dividends declared but unpaid, employee entitlements, and anything else the buyer classifies as debt-like. The debt-like items list is a negotiation in itself.
What a diligence team looks for underneath
Revenue concentration. How much of your revenue comes from the largest few customers, whether they are contracted, and what happens on a change of control.
Contract quality. Notice periods, change of control clauses, whether contracts are with the entity being sold.
Margin trends by product, customer and period. A stable headline margin can conceal a deteriorating core offset by a temporary gain.
Gross margin bridge. What actually drove the movement between periods: volume, price, mix, or cost.
Cash conversion. Whether the reported profit turns into cash. Persistent divergence between EBITDA and operating cash flow is the first thing an experienced reviewer looks at.
How to prepare
Do it to yourself first. Commission vendor due diligence, or at minimum build your own adjusted EBITDA with evidence for each adjustment. Issues you find are yours to fix. Issues the buyer finds are price.
Evidence every adjustment. A schedule with supporting documents for each add-back. Adjustments you can prove survive. Adjustments you assert get removed.
Fix the data room before it opens. Contracts signed and filed, management accounts that reconcile to statutory accounts, a clean audit trail from ledger to reported numbers.
Stop optimising the numbers. Any manipulation in the twelve months before a sale will be found, and the consequence is not just that adjustment. It is that the buyer discounts everything else you have said.
The commercial point
Every pound of sustainable EBITDA is worth a multiple of itself. An adjustment of £200,000 at a multiple of six moves the price by £1.2 million. That is why diligence teams spend so long on it, and why the preparation is worth doing properly.