What is a Quality of Earnings review?
A Quality of Earnings review examines what reported profit represents and which elements may be sustainable. It can consider revenue patterns, recurring costs, accounting judgements, proposed adjustments and cash conversion. It is often a workstream within financial due diligence, but the specific scope and output must be agreed.
Test adjustments in both directions
An adjustment is a proposition that needs evidence. A genuine one-off cost may warrant consideration, while temporary income or an omitted recurring cost may reduce sustainable earnings. Check whether an apparently exceptional item recurs, whether the cost will cease and whether a replacement cost arises. Do not treat every owner-related cost as an automatic add-back.
Examine revenue and the cost of delivering it
Look at changes in sales mix, concentration, billing, collection and the resources needed to fulfil the work. Distinguish recurring activity from projects or unusual transactions. Review relevant period cut-off and accounting treatment from the available records. A growing revenue total can conceal falling margins or greater dependence on one customer.
Connect earnings to cash and the transaction
A sustainable profit assessment is not the same as cash available to shareholders. Working capital, investment, debt, transaction definitions and payment terms also matter. Explain how the earnings conclusion will be used and avoid combining incompatible measures or double-counting the same adjustment.
Worked example: adjustments can reduce EBITDA
| Hypothetical earnings bridge | Amount |
|---|---|
| Reported EBITDA | £500,000 |
| Add evidenced non-recurring expense | + £40,000 |
| Deduct ongoing replacement management cost not in the starting figure | − £60,000 |
| Remove non-recurring income included in EBITDA | − £25,000 |
| Illustrative adjusted EBITDA | £455,000 |
The arithmetic is illustrative, not a client result or recommended adjustment. Each treatment depends on the evidence and the precise starting measure. This example does not select a valuation multiple or establish company value.
Make the conclusion traceable
Keep a bridge from reported to adjusted earnings, with the period, amount, rationale, evidence and any uncertainty for each item. Where facts are unresolved, show the sensitivity instead of hiding the issue in a single adjusted total. The output should explain what was investigated and what remains outside scope.
Discuss the records, purpose, users and deadline before commissioning. A Quality of Earnings review is not an audit, automatic assurance or a guaranteed transaction outcome.