What Buyers Mean When They Say “Quality of Earnings”

Quality of earnings is one of the most commonly used and least understood terms in M&A. 

Many buyers and sellers assume it simply means confirming that the financial statements are accurate. In reality, quality of earnings is about something much more specific. Buyers want to understand whether the earnings they are buying are sustainable, repeatable, and transferable after closing.

That distinction matters because valuation is based on future earnings, not historical accounting results. 

Reported Earnings vs Real Earnings

Most small and mid sized businesses are run efficiently for tax and operational reasons, not for sale readiness. As a result, reported earnings often include items that will not exist for a buyer or exclude costs that will. 

Common examples include:

• Owner compensation that is above or below market

• Personal expenses run through the business

• Related party transactions

• One time or nonrecurring costs

• Timing differences in revenue or expenses

None of these are inherently problematic. But without adjustment, they distort the true earning power of the business.

Quality of earnings focuses on normalizing these items so buyers can understand what the business would earn under their ownership. 

Why Buyers Care About Earnings Quality

When buyers underwrite a deal, they are not asking whether the business made money last year. They are asking whether the business will reliably generate cash after they take over.

Poor earnings quality increases perceived risk. Higher risk leads to:

• Lower valuation

• More aggressive deal terms

• Earnouts or holdbacks

• Increased scrutiny during diligence

Strong earnings quality has the opposite effect. It supports valuation and creates confidence that the numbers will hold up post closing.

Common Adjustments Buyers Focus On

During buy side financial due diligence, buyers and their advisors typically focus on a few key areas.

Owner compensation and benefits

Buyers adjust earnings to reflect market-based compensation for the role the owner performs.

One time or nonrecurring items

Legal costs, system implementations, unusual repairs, or COVID related impacts are removed to reflect ongoing operations.

Related party transactions

Rent, management fees, or shared services are adjusted to market terms.

Revenue sustainability

Buyers look closely at whether revenue is recurring, contract based, or relationship driven.

Each adjustment improves clarity around normalized EBITDA, which is the foundation for valuation.

Quality of Earnings Is Not About Finding Fault

One misconception is that a quality of earnings analysis exists to find problems or discredit the seller.

In practice, most findings are neutral. They simply clarify how the business operates. Deals rarely fail because of quality of earnings. They fail when expectations are misaligned.

When buyers and sellers agree on normalized earnings early, transactions tend to move faster and with fewer surprises.

How Quality of Earnings Fits Into Buy Side Financial Due Diligence

Quality of earnings is not a standalone exercise. It is a core component of buy side financial due diligence.

It connects directly to:

• Valuation

• Working capital targets

• Debt capacity

• Deal structure

Without understanding earnings quality, buyers are negotiating price and terms on incomplete information.

The Bottom Line

When buyers ask about quality of earnings, they are not questioning integrity. They are assessing risk.

Understanding earnings quality helps buyers price deals appropriately and helps sellers explain the true economics of their business. In a transaction, clarity creates momentum. Assumptions create friction. Disclaimer: The information in this article is provided for general educational purposes only and reflects the author’s opinion. It should not be relied upon as formal financial, accounting, or legal advice. Owners and buyers should consult qualified professionals before making decisions based on this content.