Quality of earnings

Anchored to
The stage where most price is won or lost

What it actually is

A quality of earnings review is an accountant's attempt to answer one question: if I owned this business next year and nothing changed, what would it actually earn. It is not an audit. An audit asks whether the statements comply with a framework. A quality of earnings review asks whether the profit is real, repeatable and transferable.

The output is a bridge from reported profit to adjusted earnings, with every step supported. That adjusted figure is what the buyer finances against, what the lender tests coverage on, and what any multiple gets applied to. Everything else in the negotiation is downstream of it.

Add-backs, and the ones that survive

Owner-managed businesses run personal and discretionary costs through the company. Adding those back is legitimate. The distinction a buyer's accountant draws is between costs a new owner genuinely will not incur and costs the seller would simply prefer not to count.

Adjustments that generally survive scrutiny share three features: they are documented, they are clearly personal to the current owner, and they are one-directional. An above-market owner salary, a vehicle used privately, a family member on the payroll who does not work in the business, a genuinely one-off legal matter with an invoice attached.

Adjustments that generally do not survive: unvouched cash, "lost sales we would have made", deferred maintenance recast as a saving, and anything described as one-off that has appeared in three consecutive years. The last of those is the one sellers argue hardest for and lose most often.

A rule worth internalising before diligence: an add-back you cannot evidence is not worth less than the others, it is worth less than nothing. Each one that fails makes the accountant look harder at the ones that would otherwise have passed.

Where sellers lose money

Not usually in the total. Usually in the sequence. The seller sets an expectation on a number they have used internally for years, the buyer's accountant reduces it, and the price falls from an anchor that was already public. Had the same seller started from the defensible number, they would have negotiated from strength and often finished higher.

The second loss is time. Reconstructing support for three years of adjustments while a buyer waits adds weeks to a process, and processes that run long fail more often.

Doing it before the buyer does

A sell-side quality of earnings review is the same exercise commissioned by the seller first. It costs real money and it does three things worth more than it costs. It replaces the seller's number with one that has already survived professional scrutiny. It finds the problems while there is still time to fix or explain them. And it shortens buyer diligence, because the buyer's accountant is reviewing an existing analysis rather than building one.

It also changes the tone of the negotiation. A seller who hands over a supported bridge is a different counterparty from one who hands over a shoebox.

Quality, not just quantity

The name is exact. Two businesses with identical adjusted earnings are not worth the same if one earns from contracted recurring revenue across many customers and the other from project work won repeatedly from three. Buyers pay for durability, and the quality discussion is where durability gets examined: revenue concentration, contract length, pricing power, whether margin is stable or has been propped up by one favourable input, and whether the earnings depend on the owner being there.

Which is why this exercise sits upstream of everything else on this site. It sets the number that the financing arithmetic then works on.