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Quality of earnings report guide
A transaction-focused guide to adjusted EBITDA, revenue quality, net debt, working capital and the questions a buyer or advisor should ask when reviewing a quality of earnings report.
01
What a quality of earnings report establishes
A quality of earnings report tests how much of a company's reported profit is sustainable, recurring and convertible into cash. It is not an audit opinion and it does not simply restate the income statement. Its purpose is to explain the economic earnings a buyer is acquiring and the adjustments that may affect value or transaction terms.
The analysis typically begins with reported EBITDA and builds a documented bridge to adjusted EBITDA. It then tests revenue durability, margin development, customer concentration, working capital and cash conversion. Each adjustment should be supported by source data and classified as recurring, non-recurring, run-rate or pro forma.
02
The adjusted EBITDA bridge
The EBITDA bridge is the central schedule in a quality of earnings report. It reconciles reported results to a maintainable earnings basis without obscuring the accounting record. A clear bridge states the period, source account, rationale, evidence and recurring status for every adjustment.
Non-recurring items
Transaction costs, restructuring, litigation, insurance recoveries and other events that are not expected to repeat.
Owner and related-party items
Compensation, rent, management charges or personal expenses that differ from arm's-length terms.
Accounting normalisation
Differences in revenue recognition, provisioning, capitalisation or inventory policy that require a consistent basis.
Run-rate adjustments
The full-period effect of price changes, contract wins or losses, sites opened and headcount added during the period.
Pro forma adjustments
Acquisitions, disposals, standalone costs or changes that depend on the contemplated ownership structure.
03
Revenue quality and margin analysis
Reported growth is separated into price, volume, mix, acquisitions and foreign exchange where relevant. The review should reconcile detailed revenue data to the general ledger before analysing customer concentration, retention, churn, contract terms and period-end cut-off.
Gross margin and EBITDA movement are then bridged by operating driver. This distinguishes structural improvement from temporary price effects, favourable mix, under-accruals or cost deferral. The objective is not to produce a preferred narrative, but to show which earnings drivers are evidenced and repeatable.
04
Net debt and debt-like items
A quality of earnings workstream often informs the enterprise-value-to-equity-value bridge. The analysis identifies obligations that may be treated as debt-like and cash balances that may not be freely available. The final treatment depends on the sale and purchase agreement and should remain consistent with the EBITDA definition.
Financing obligations
Bank debt, overdrafts, shareholder loans, accrued interest, break costs and relevant lease liabilities.
Deferred obligations
Earn-outs, deferred consideration, unpaid capital expenditure and overdue creditors outside normal trading terms.
Employee and tax items
Accrued bonuses, retention payments, leave, pension or gratuity balances, and identified tax exposures.
Cash adjustments
Restricted, trapped or minimum operating cash that is not available for distribution at completion.
05
Working capital and cash conversion
The working capital review determines the normal liquidity required to operate the business and supports negotiation of the completion peg. Monthly balances are analysed over a period long enough to capture seasonality, growth and changes in trading terms. Receivables, inventory, creditors, accruals and deferred revenue are tested for ageing, classification and unusual movements.
Cash conversion provides a cross-check on earnings quality. Adjusted EBITDA is bridged to operating and free cash flow, including working capital movements, taxes and maintenance capital expenditure. Weak conversion does not automatically invalidate earnings, but it must be explained by business economics rather than presentation choices.
06
How to review the report
A useful report allows a transaction team to trace every significant conclusion back to the underlying data. Reviewers should test whether adjustments are evidenced, whether the same item appears elsewhere in net debt or working capital, and whether run-rate assumptions are consistent with the forecast.
Traceability
Can each adjustment be followed from the report to the databook, trial balance and supporting document?
Consistency
Are EBITDA, net debt and working capital definitions aligned without omissions or double counting?
Sensitivity
How does the valuation or covenant position change if judgemental adjustments are excluded?
Deal consequence
Does each finding affect price, the completion mechanism, warranties, indemnities or post-close planning?
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