Quality of Earnings Analysis for Better Deals

A target may report strong EBITDA, a growing order book, and favorable management accounts, yet still fail to deliver the earnings a buyer believes it is acquiring. The gap usually appears after closing, when one-off revenue disappears, working capital proves inadequate, claims surface, or costs deferred before the transaction arrive in the following reporting period. Quality of earnings analysis is designed to identify those gaps before price, structure, and risk allocation are fixed.

For boards, investors, and acquirers, the exercise is not simply a challenge to accounting policy. It is an assessment of whether profit is recurring, cash-backed, properly measured, and capable of being transferred to a new owner. It also provides a disciplined fact base for negotiations, earn-out design, financing discussions, and, where necessary, later disputes.

What Quality of Earnings Analysis Actually Tests

Reported earnings are an accounting outcome. Quality earnings are an economic outcome. A company can comply with applicable accounting standards and still present earnings that require substantial normalization before they can support valuation.

A quality of earnings review reconciles management's reported results to underlying commercial activity. It considers revenue recognition, customer terms, pricing, gross margin behavior, operating costs, cash conversion, balance sheet movements, and the assumptions that connect each period to the next. The objective is not to find every immaterial adjustment. It is to determine what a prudent buyer can reasonably expect to earn on a continuing basis.

A useful analysis distinguishes among three categories. Recurring earnings arise from ordinary operations and are likely to continue. Nonrecurring items are genuine but unusual, such as a discrete settlement, a one-time project mobilization recovery, or exceptional professional fees. Unsustainable earnings may appear normal in the accounts but rest on aggressive cut-off practices, unperformed obligations, related-party arrangements, under-accrued costs, or revenue that lacks sufficient commercial substance.

Cash flow matters, but it is not a substitute for analysis. A fast-growing business may consume cash because it is funding legitimate expansion, while a mature business may report profit without cash because receivables are aging or contract assets are accumulating. The question is whether the cash profile follows from a credible operating model and whether the required working capital has been reflected in the transaction.

Quality of Earnings Analysis in a Deal Process

The work should begin early enough to affect the transaction, rather than becoming a post-signing confirmation exercise. A preliminary review may identify issues that require a lower valuation, a different enterprise value to equity value bridge, a completion accounts mechanism, a specific indemnity, or an earn-out tied to cash collection rather than booked revenue.

Revenue testing often receives the most attention, particularly in businesses with long sales cycles, project milestones, channel partners, or significant year-end activity. The adviser should trace material revenue to contracts, delivery evidence, customer acceptance, invoices, subsequent receipts, credit notes, and any side arrangements. Large contracts signed close to period-end deserve attention, but so do routine contracts whose renewal rates, pricing concessions, or margin profile have quietly changed.

Margin analysis should follow revenue analysis. A company can recognize sales appropriately while understating the cost of delivering them. Common examples include delayed hiring, unrecorded subcontractor claims, capitalization of costs that should be expensed, inadequate warranty provisions, and management charges that will change following a sale. For owner-managed companies, adjustments for shareholder compensation, personal expenses, and related-party transactions may be necessary, but they should be supported by market evidence rather than simply labeled discretionary.

Working capital is frequently where an apparently attractive EBITDA figure loses practical value. Receivables may include disputed balances, retainage, old intercompany amounts, or invoices not collectible on ordinary terms. Inventory may be slow-moving or obsolete. Payables may be temporarily suppressed before closing. A review should connect the proposed working capital target to the company's normal operating cycle, seasonality, customer concentration, and forecast growth.

Debt-like items require equal care. Unpaid taxes, accrued bonuses, litigation exposures, lease obligations, customer deposits, deferred revenue obligations, and certain pension or remediation costs may not be obvious from a headline net debt schedule. Whether an item is debt-like, working capital, or a specific negotiated adjustment depends on the transaction documents and commercial context. The accounting label alone does not settle the issue.

When Operational Records Change the Earnings Story

In construction, engineering, and underground works, the general ledger is only one part of the evidence. Reported project profit may rely on estimated completion percentages, variation orders, claims recoveries, liquidated damages assumptions, or anticipated approval of additional work. Quality of earnings analysis must therefore test project reporting against signed contracts, certified progress claims, site instructions, cost-to-complete updates, correspondence, and contemporaneous technical records.

Geotechnical and underground projects present particular uncertainty. Differing ground conditions, water ingress, access constraints, design changes, and interface risk can turn a profitable forecast into a loss-making contract quickly. An unresolved claim may have merit, but it is not equivalent to cash or confirmed revenue. A prudent review considers the contractual basis, available notices, expert support, counterparty conduct, legal advice where appropriate, and the history of recovery on comparable claims.

The professional liability position of a practicing professional engineer or qualified person can also affect earnings and valuation. Where design responsibility, supervision obligations, certification, or conflicts of interest are in question, the exposure may extend beyond a single project. Potential insurance recoveries, deductibles, exclusions, notification requirements, and reputational consequences should be assessed separately from management's operating forecast. Treating a contingent professional claim as a remote footnote may be inappropriate where the available project record suggests otherwise.

Record discipline is therefore a financial control as well as a legal safeguard. Boards should expect clear approval trails for scope changes, project forecasts, related-party arrangements, material settlements, and judgments affecting revenue or provisions. Meeting minutes should record the information considered, competing views, conflicts declared, and reasons for material decisions. In a later arbitration, fraud investigation, or court proceeding, a contemporaneous record is far more persuasive than an explanation reconstructed after a transaction has failed.

Governance, Incentives, and the Risk of Managed Earnings

The most significant issues are often behavioral rather than mechanical. A management team preparing for a sale, financing round, or public listing may face intense pressure to achieve a target EBITDA figure. That pressure does not establish misconduct, but it should shape the review plan. The adviser should understand who approves revenue entries, who can alter project forecasts, how bonuses are calculated, and whether finance personnel can challenge commercial leadership without consequence.

A review of executive compensation can be relevant where incentives reward bookings, reported EBITDA, or milestone completion without regard to collections, customer acceptance, claim validity, or subsequent margin erosion. Well-designed incentives do not eliminate risk, but they reduce the temptation to bring earnings forward or defer unfavorable costs. Boards should also consider whether a senior executive's grievance concerning compensation, authority, or treatment may create a governance issue requiring an independent and documented response.

Where anomalies suggest possible fraud, the scope must shift from ordinary financial due diligence to a controlled forensic process. That may involve preserving relevant documents, limiting access to sensitive materials, conducting independent interviews, and coordinating with legal counsel on privilege and reporting obligations. Premature accusations can damage the business and compromise evidence; passive acceptance of unexplained exceptions can expose directors and investors to greater harm.

Scope Should Follow the Decision at Hand

There is no single depth of review suitable for every mandate. A minority investor may focus on revenue concentration, cash conversion, and downside cases. A buyer acquiring control may require detailed testing of project profitability, working capital, tax exposures, and management adjustments. A board facing a valuation dispute may need analysis that is sufficiently documented to withstand scrutiny from opposing experts, arbitrators, or the court.

The review should also be calibrated to the reliability of information. A company with audited financial statements, stable contracts, and strong internal controls may justify targeted procedures. A fast-growing business with manual reporting, related-party activity, cross-border operations, or contentious projects may require broader work and direct access to underlying records. A narrow scope can be commercially sensible, but it should be a conscious risk decision, not a consequence of an accelerated timetable.

The most useful outcome is not a long list of adjustments. It is a clear view of the earnings that can support a valuation, the assumptions that remain unproven, and the protections required if those assumptions are wrong. That clarity gives decision-makers a better basis to negotiate firmly, document responsibly, and proceed only on risks they have deliberately chosen to accept.