Quality of earnings, explained for buyers and sellers

In any acquisition of an SME or startup, one phrase appears the moment the numbers turn serious: quality of earnings. Behind the jargon sits a simple, formidable idea. The profit shown in the accounts is only a starting point. The real question is not how much the company earned last year, but how much of that profit is recurring, collectible and reproducible without the seller. A quality of earnings analysis, often shortened to QoE, answers exactly that. It is one of the most decisive pieces of acquisition due diligence, and the one sellers most often underestimate. This article explains it from both sides of the table, because understanding the other side’s reading is the best way to defend your own.

Quality of earnings: the useful definition

Quality of earnings measures how faithfully reported profit reflects the real, durable economic performance of the business. High quality earnings are recurring, backed by cash actually collected, generated by diversified activity and independent of the founder’s presence. Low quality earnings rest on one off items, accounting entries with no cash flow, one or two clients, or costs the seller artificially squeezed just before the sale. Two companies can both report €800,000 of profit: one deserves a full multiple, the other a steep discount. QoE is the work that reveals which is which.

The buyer is not paying for last year’s profit. They are paying for the company’s ability to generate that profit next year, without the seller and without surprises.

In practice, a quality of earnings analysis rebuilds EBITDA over three financial years, normalizes it, then tests it against the cash actually produced. It never stops at the income statement: it links earnings to the balance sheet and to cash flow, because the junction of the three is precisely where the illusions hide.

The four tests that define quality

To assess the quality of a profit, ask four questions in order. They form a simple grid you can apply to any target.

• Recurrence: how much of the profit will come back next year without fresh effort? A multi year subscription is worth far more than a one off project booked once.
• Collection: does the profit turn into cash? Net profit of €500,000 sitting next to operating cash of €100,000 should raise an alarm: the profit exists on paper but not in the bank.
• Diversification: does the profit depend on a handful of clients, a single supplier or favorable regulation? Concentration turns a good number into a risk.
• Independence from the owner: does the profit survive the founder’s departure, or does it rest on their relationships, their network and their unpaid time?

Normalization adjustments, the buyer’s side

The heart of a QoE is the bridge from reported EBITDA to normalized, or adjusted, EBITDA. The buyer removes what will not recur and adds what is structurally missing. Take a target reporting €1,000,000 of EBITDA. Here is how the bridge is built, in round, purely illustrative figures.

• Below market owner pay: the founder draws €80,000 while a salaried manager would cost €180,000. Deduct €100,000, because it is a real cost for the buyer.
• Private spending booked as expense: a high end car, travel, personal subscriptions, totaling €60,000. Add it back only if it genuinely disappears after the sale.
• Related party rent: the business rents its premises from the seller’s property company at €40,000 below market. Correct to market, because that is what you will pay.
• Exceptional income: an insurance payout of €120,000 collected once. Remove it, it will not return.
• Missing cost: no budget to replace a critical piece of software at end of life, around €50,000 a year to provision. Add it.

The bridge then reads: €1,000,000 reported, minus €100,000 to bring pay to market, plus €60,000 of genuinely removable private spending, plus €40,000 of corrected rent, minus €120,000 of exceptional income, minus €50,000 of missing software cost. Normalized EBITDA: €830,000. At a multiple of 5, the gap between the reported figure and the normalized figure moves the price by €850,000. That is the whole point: in this example, every €100,000 of EBITDA adjustment moves the price by €500,000.

The decisive test: does profit turn into cash?

A profit can be perfectly recurring and yet never reach the bank. That is the working capital trap. I have analyzed targets that were profitable on paper yet whose operating cash never caught up with reported profit, year after year. The mechanism is always the same: a growing business that pays suppliers in 30 days and collects from customers in 90 permanently finances its own sales. The faster it grows, the more cash it absorbs, even as its profit climbs. A good quality of earnings analysis computes the rate at which profit converts to cash over several years. If it stays low year after year, the buyer must plan to inject working capital from the very first month, on top of the price, and deduct it from what they are willing to pay.

Look as well for timing manipulation around the sale date: invoicing pulled forward, costs pushed into the next year, inflated inventory, provisions released without justification. When a profit jumps in the year before the sale, I look first for the operational cause. When there is none, it is almost always a profit manufactured for the file. Our guide on analyzing the acquisition of an SME or startup sets out these mechanics layer by layer and carries the work described here a step further.

The seller’s side: preparing your quality of earnings

If you are selling, QoE is not a threat but an opportunity, provided you anticipate it. The biggest mistake I see on the seller side is to discover the buyer’s adjustments during due diligence, in a defensive position, once the letter of intent is signed and every correction translates into a lower price. There is a counter: commission your own quality of earnings analysis, known as a vendor QoE, before you even bring the business to market. It lets you present a credible, documented, defensible normalized EBITDA rather than inherit the buyer’s.

• Clean the accounts in advance: take out private spending, clarify related party dealings, align your pay with the market at least two financial years before the sale.
• Document every adjustment: adding back a non recurring cost only holds if it is backed by evidence. With no proof, the buyer will reject it.
• Improve cash conversion: shorten customer payment terms, clean up inventory, show that profit really lands in the bank. It is the most convincing quality signal there is.
• Defuse owner dependence: hand over key client relationships, formalize processes, show a team that can run without you.

A seller led quality of earnings does not remove the adjustments: it anticipates them, documents them, and takes away the buyer’s easy arguments for cutting the price.

How quality of earnings translates into price

Quality of earnings acts on the price through two levers at once. First the base: it is normalised EBITDA, not reported EBITDA, that the multiple is applied to. Then the multiple itself: earnings that are highly recurring, well collected and independent of the founder justify the top of the range, while concentrated, irregular or hard to convert earnings pull the multiple down and call for protections. Those protections are the other language of QoE: a vendor loan, an earnout tied to sustained EBITDA or client retention, a liability guarantee and a price holdback. An identified flaw does not always sink the deal, it turns into a clause.

In the end, quality of earnings is a shared language. The buyer uses it to avoid overpaying for profit that will evaporate after closing; the seller, to prove their profit is solid and earn the price it deserves. If you are studying a target or preparing a sale, have the quality of earnings analyzed before you set a price: it is the work that pays back the most, because it bears directly on the only thing that truly matters, the economic reality behind the number.

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