Quality of Earnings Due Diligence: Testing Whether EBITDA Is Repeatable

Quality of earnings due diligence asks whether reported profit arises from repeatable operations, is measured consistently and can convert into cash without hidden capital demands. It does not simply recalculate EBITDA. It builds a traceable bridge from statutory accounts to reported EBITDA, tests proposed adjustments, analyses the underlying commercial drivers and produces a sustainable earnings range for valuation and financing.

What quality of earnings is—and is not

EBITDA is a performance measure, not cash flow, and adjusted EBITDA is not uniformly defined. A quality of earnings review therefore begins with definitions. Reconcile audited profit after tax through interest, tax, depreciation and amortisation to reported EBITDA, then bridge every management adjustment to the ledger and source evidence.

The aim is not to maximise adjusted EBITDA. It is to distinguish:

• accounting errors or classification differences;
• genuinely non-recurring items;
• owner-specific or related-party effects;
• run-rate changes supported by evidence;
• normal operating costs that must remain; and
• forecast improvements that belong in valuation scenarios, not historical earnings.

A credible report shows both positive and negative adjustments and applies consistent principles across periods.

Build the earnings bridge at transaction level

Start with monthly trial balances and reconcile them to audited financial statements, management reporting and tax records. Map changes in account codes or policies so that period comparisons are like-for-like. Analyse at least enough history to capture seasonality and important changes in the business; the appropriate period depends on the target and cycle.

For every adjustment, record the amount, period, evidence, rationale, tax treatment where relevant and whether it is recurring, non-recurring or prospective. Avoid labels such as exceptional without testing frequency. An expense that recurs irregularly—major repairs, claims, recruitment, product launches or professional fees—may still be a normal cost of operating.

Use a range when evidence cannot support a single value. State separately any matter that changes enterprise value, net debt, working capital or future capex to prevent double counting.

Test revenue quality before margin

Revenue deserves transaction-level attention because timing, terms and collectability can materially change earnings. Ind AS 115 focuses on the transfer of promised goods or services and the consideration an entity expects to receive; the applicable accounting framework must be assessed by qualified accountants. Diligence should test whether the commercial substance and accounting treatment align.

Select samples around period ends and trace customer orders, contracts, dispatch or service evidence, invoices, credit notes, returns and cash receipts. Investigate bill-and-hold arrangements, unbilled revenue, manual journals, side agreements, extended payment terms and channel stock. Compare revenue recognition with operational records such as production, shipment, installation or acceptance.

Then analyse revenue by customer, product, geography and month. Separate price, volume, mix, currency and acquisitions. A year-on-year increase can be low quality if driven by an isolated order, shortened lead times that pulled demand forward, unsustainable discounts or a customer with worsening collections.

Examine gross margin and operating costs

Rebuild gross margin with consistent classification. Check standard-cost variances, inventory absorption, purchase rebates, freight, scrap, warranty, labour and utilities. In manufacturing, under-absorbed or over-absorbed overhead and changes in inventory can distort the relationship between production and sales. Compare margin with throughput, yield and commodity inputs.

Below gross margin, inspect payroll, commissions, rent, maintenance, professional fees, technology and marketing. Reconcile headcount and payroll records, examine vacancies and capitalised costs, and identify expenses borne by owners or related parties. If a target occupies promoter-owned property below market rent, normalisation should use supportable arm's-length economics—not an arbitrary uplift.

Run-rate savings require particular discipline. A signed lease exit or completed headcount reduction differs from an unapproved plan. Show prospective synergies separately because they depend on buyer actions and execution risk. Seller-specific add-backs should not be confused with buyer-specific value.

Connect EBITDA to cash and working capital

Repeatable EBITDA can still be a poor basis for value if it needs growing working capital or deferred capital expenditure. Bridge EBITDA to operating cash flow through receivables, inventory, payables, provisions and taxes. Analyse days and ageing by month, subsequent cash collection, disputed balances and supplier payment patterns.

Look for earnings supported by overdue receivables, excess inventory or stretched creditors. A temporary working-capital release can boost cash while weakening supplier relationships or future availability. Conversely, rapid growth may consume cash even when margins are sound. The quality of earnings conclusion should therefore state both earnings sustainability and the cash investment required to support it.

Examine maintenance and compliance capex alongside depreciation and asset condition. EBITDA excludes depreciation, but machinery still wears out. If maintenance has been deferred, the economic cost may appear as near-term cash needs, downtime or reduced output rather than an EBITDA adjustment.

Common adjustments and the evidence test

An adjustment should be symmetrical. If unusual costs are removed, unusual gains should also be assessed. Consistency across historical periods matters as much as the current-year number.

Translate findings into valuation and terms

Present reported, adjusted and sustainable EBITDA rather than one opaque number. Show downside and upside cases with drivers. If valuation uses an EBITDA multiple, even a modest earnings adjustment can be magnified, so identify confidence and avoid false precision.

Some findings belong elsewhere in the deal model. A tax exposure or unpaid capex invoice may be debt-like; excess or deficient working capital may be captured at completion; a customer renewal risk may affect the multiple or an earn-out. Establish one cross-workstream issues register to prevent the same matter being reflected twice.

Conclusion

Good quality of earnings diligence makes EBITDA explainable. It tests the accounting against contracts, cash and operations, rejects unsupported adjustments and separates historical normalisation from future opportunity. The output is not a more attractive number; it is a defensible earnings range and a clearer view of what the buyer must fund, protect and execute.