Quality of earnings, explained simply
A QoE separates earnings that will continue from earnings that will not. Reported EBITDA is restated for non-recurring items, owner-related costs at non-market rates, accounting errors and known changes in the business.
The result, adjusted EBITDA, is the earnings base on which purchase price, debt capacity and covenants are set.
From reported to adjusted EBITDA
IllustrativeAlder Creek Manufacturing, last twelve months, $ millions
At 8.0×, the $0.40m earnings difference is worth $3.2m of price.
How a QoE is performed
- Start with reported EBITDA, reconciled to the trial balance.
- Remove one-off gains and costs.
- Bring owner-related costs to market rates.
- Correct accounting errors, such as missing accruals and cut-off.
- Adjust for known changes, such as a new contract or a closed location.
Worked example
| Alder Creek, last twelve months | $ millions |
|---|---|
| Net income | 2.90 |
| Add: interest | 0.50 |
| Add: income taxes | 0.80 |
| Add: depreciation and amortization | 0.80 |
| Reported EBITDA | 5.00 |
| Less: one-off gain on equipment sale | (0.60) |
| Add: owner salary above market rate | 0.25 |
| Add: one-off legal settlement | 0.30 |
| Less: bonuses earned but not recorded | (0.20) |
| Less: below-market rent paid to the owner’s property company | (0.15) |
| Adjusted EBITDA | 4.60 |
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
At a multiple of 8.0x, the $0.4 million difference between reported and adjusted EBITDA is worth $3.2 million of price.
Why it matters in a deal
Price, loan quantum and financial covenants are usually set on adjusted EBITDA. A credible QoE narrows disputes over price and shortens the path to signing.
Red flags
- Nearly all adjustments increase EBITDA and few reduce it
- “One-time” costs that recur every year
- Add-backs that represent a large share of reported EBITDA
- Adjustments with no supporting documents