What it means
Begin with reliable historical accounts and reconcile them to source records, because a strong sales month may not be repeatable if it reflects an exceptional contract or early recognition. The review asks what actually happened and whether it belongs in a reasonable run-rate view.
Adjustments can increase or decrease an earnings measure: owner expenses that will genuinely disappear may be added back, while under-market rent or a missing replacement salary may reduce adjusted earnings, and a seller should not call every recurring inconvenience a one-off simply to improve the number. Examine timing and accounting policy, since revenue booked before the relevant work is done, deferred maintenance or understated provisions can distort a period.
Compare contracts, invoices, fulfilment and subsequent credits rather than relying only on management's account. Customer and product concentration also matter, because a high-margin contract that ends next month should not be treated as equal to a diversified recurring base, so the reviewer may examine churn, backlog, price changes and margin by cohort to understand what can reasonably continue.
EBITDA is not cash flow, because inventory, receivables and payables absorb or release cash as the business grows or shrinks. Capital spending may be needed to sustain operations even if it does not appear in current EBITDA, so earnings can still require funding.
A cash conversion ratio can prompt questions, but there is no universal threshold that proves earnings quality, since seasonality, growth and investment change working capital and cash patterns, so review several periods and the underlying causes rather than assuming a ratio below one is automatically bad. Use a bridge from reported to adjusted results showing item, amount, sign, period, evidence and rationale, with disputed adjustments shown separately.
A transparent bridge is more useful than one precise total that hides disagreements about rent, founder pay or an expected customer loss. An independent report can help a buyer and seller discuss a price, but it does not decide the price on its own.
Multiples, debt, working capital, growth, legal risk and negotiation all affect a deal, so do not present an adjusted EBITDA figure as an agreed transaction value. For an owner planning a sale, keep records consistent and explain unusual events before diligence begins.
Cleaner records can reduce surprises but do not guarantee a higher multiple, and the goal is an honest basis for judging sustainable results and cash needs.
In practice
Real-world examples.
Example
A company reports net profit of $2 million, but $800,000 came from selling a building. Its underlying earnings are $1.2 million, which is what a buyer will value.
Example
A distributor's profit grows 25%, but operating cash flow falls because receivables doubled after it extended credit to weak customers. The earnings are of lower quality than they look.
Example
A buyer's QoE review finds that the seller's owner paid himself only $30,000 a year, well below a market salary of $150,000. Adjusted earnings are cut by $120,000.
Formula
Calculation
Illustrative adjusted EBITDA = reported EBITDA + supported non-recurring costs - supported non-recurring gains +/- normalising and timing adjustments. Each item needs a reason, evidence and a consistent period.
Worked example. A fictional seller reports EBITDA of $3,000,000. Remove a $400,000 asset-sale gain, add back $150,000 in supported one-off legal costs, then deduct $120,000 for below-market owner pay and $230,000 of revenue recognised too early.
- Adjusted EBITDA = $3,000,000 - $400,000 + $150,000 - $120,000 - $230,000 = $2,400,000.
At six times EBITDA, $2,400,000 implies $14,400,000 before other deal adjustments, compared with $18,000,000 using the unadjusted number. Neither figure is a binding price or a forecast.Case study
Seen in the real world.
This illustrative and entirely fictional example follows Horizon Packaging, an invented manufacturer preparing for a sale. It has strong reported earnings, but the buyer asks why cash flow lags and whether the warehouse rent reflects market cost. The review finds a one-time asset gain, supplier rebates recorded in a different period and a family-owned warehouse rented below market. It also identifies inventory growth that will require more cash if sales expand.
The parties discuss each adjustment with contracts and transaction evidence. Horizon updates its records and forecasts before continuing negotiations. It cannot promise a later sale price from the review alone. The value of the exercise is that buyer and seller can see the same bridge and debate the assumptions openly.
Watch out
Common mistakes.
- Adding back recurring costs as if they will vanish after a transaction.
- Treating EBITDA as cash flow without working-capital or capital-spending review.
- Converting an adjusted-earnings multiple directly into a guaranteed sale price.
Questions
People also ask.
What is a quality of earnings report?
It is a review of historical earnings and adjustments relevant to an ongoing run rate; it is not an audit or forecast.
How can I tell if earnings are high quality?
Look at supported recurring revenue, accounting timing, cash needs, concentration and adjustments in both directions.
Why does quality of earnings matter to business owners?
Credible earnings can inform valuation, but the price also depends on risks, cash, debt, working capital and negotiation.
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