Quality of earnings in a 4-week buy-side review: our approach.
Our FDD practice, in detail.
1. What QoE is, and what it is not.
Quality of earnings is the work-stream within a buy-side FDD that produces an adjusted, maintainable EBITDA - the number the acquirer uses for valuation, the number the SPA references, and the number the post-deal management team will be measured against.
QoE is not an audit; it does not produce an opinion. It is a normalisation exercise. The starting point is the target's reported EBITDA; the ending point is a bridged, adjusted EBITDA with each adjustment documented and defended.
A useful QoE answers two questions clearly: what did the business actually earn last year (LTM) and what should we expect it to earn on a steady-state basis going forward? The two answers will differ where the LTM contained items that are non-recurring, owner-related, or accounting-policy-driven.
2. Week 1: building the data foundation.
Week 1 is data, not analysis. The objective is to receive the full set of inputs, tie them back to audited or reviewed financials, and document the data sources so that every adjustment in the next three weeks has clean evidence.
Standard data requests:
- Audited financials for the last 3 to 5 years.
- Management accounts for the LTM (last twelve months), monthly.
- Trial balance for each period under review.
- Detailed P&L by product / segment / customer where relevant.
- Schedule of related-party transactions over the look-back.
- Schedule of one-time / non-recurring items already identified by management.
- Inventory ledger, accounts receivable and accounts payable ageing.
- Tax computations and pending assessments.
Every analysis in the QoE ties back to one of these primary sources. By end of week 1, the team has reconciled the data to audited or reviewed numbers and has a working model in place.
3. Week 2: identifying adjustments.
Week 2 is interrogation: every line of the P&L is examined for items that should not be in maintainable EBITDA. Five categories:
- Non-recurring items. One-off gains or losses that do not represent the business's run-rate earnings. Asset sales, insurance recoveries, restructuring costs, one-off legal settlements.
- Owner-related items. Promoter compensation above market, family members on payroll without operational roles, personal expenses booked to the business, related-party transactions at non-market terms.
- Accounting policy items. Choices the target has made that differ from buyer convention. Inventory valuation, depreciation method or rates, capitalisation threshold, revenue recognition timing.
- Out-of-period items. Revenue or cost recognised in the LTM that belongs to an earlier period (or vice versa).
- Pro-forma items. Forward-looking adjustments: contracts that have been signed but not yet contributed full annual revenue, cost savings that have been actioned but not yet realised, head-count changes already executed.
Each potential adjustment is documented with its category, the dollar quantum, and the evidence. Management is interviewed on each.
4. Week 3: drafting the bridge.
Week 3 produces the QoE bridge - the document the acquirer's deal team will work from. The bridge has a single layout:
- Reported EBITDA (per audited / management accounts).
- Plus / minus each adjustment, grouped by category, with one-line reasoning.
- Equal to Adjusted EBITDA.
- Plus / minus pro-forma items.
- Equal to Pro-forma Adjusted EBITDA.
Each adjustment is supported by a detail page in the appendix, with the calculation, the evidence (system extract, document, contract), and the management view (agreed, disagreed with reasoning, partially agreed).
Disagreements between FDD and management are not failures. They are visible in the bridge: each adjustment is marked as "Confirmed by management", "Disputed by management" or "Subject to further information". The acquirer's deal team uses the bridge to negotiate; disputed items become negotiation points.
5. Week 4: defending the number.
Week 4 is finalisation and defence. The QoE bridge goes through:
- Internal review by the FDD partner.
- Discussion with the acquirer's deal team to test each adjustment.
- Final discussion with target management on the disputed items.
- Final bridge incorporated into the FDD report.
The defended adjusted EBITDA becomes the input to the valuation. If the acquirer is paying 8x EBITDA, a ₹2 Cr adjustment in the QoE moves the price by ₹16 Cr. The discipline of getting each adjustment right has material commercial consequence.
6. The traps we look out for.
Five recurring traps:
- Cherry-picking non-recurring items. A management that wants a higher adjusted EBITDA selectively claims that costs are non-recurring (one-off lease renegotiation, one-off recruitment campaign) but treats every gain as recurring. The discipline is symmetry: if a gain in this year was one-off, last year's similar gain should also be flagged.
- Pro-forma items without evidence. "We have already actioned ₹3 Cr of cost savings" is an assertion. Without documented contracts, exits or system changes, it is not a defensible adjustment.
- Related-party reversal at "market". If the target buys raw material from a related party at a discount, the QoE typically adjusts to market price. The "market" price needs to be defended (independent quotes, comparable transactions, benchmarking studies). Management's view of market is not enough.
- Revenue recognition shift. Where the target's revenue recognition is aggressive (early recognition on long-term contracts, bill-and-hold sales, advance recognition on annual licences), the QoE re-states to a buyer-typical convention. This can be a meaningful adjustment in software, services and project-based businesses.
- Window-dressing in the LTM cut-off. Sales pulled forward into the LTM, costs pushed out. We compare the LTM monthly trend against historical patterns; an unusual spike in the months immediately before cut-off invites investigation.
Frequently asked
What is the difference between EBITDA and adjusted EBITDA?
EBITDA is earnings before interest, tax, depreciation and amortisation as reported. Adjusted EBITDA is EBITDA after normalising adjustments - non-recurring items, owner-related items, accounting policy normalisation. The adjusted number is what acquirers use for valuation because it represents the maintainable run-rate earnings rather than the reported number which may contain one-time effects.
What is the difference between adjusted EBITDA and pro-forma EBITDA?
Adjusted EBITDA normalises for items that have happened (and would not recur) or that need accounting normalisation. Pro-forma EBITDA additionally reflects events that have happened but whose full effect is not yet in the LTM - a customer contract signed mid-year, cost savings actioned but not fully realised, headcount changes already executed. Pro-forma adjustments require strong evidence.
How much can adjusted EBITDA differ from reported EBITDA?
It varies. In a clean, well-run business, the difference is typically 5 to 10 per cent. In businesses with significant owner-related expenses or non-recurring items, the difference can be 20 to 30 per cent. In businesses with aggressive accounting choices or owner integration, even higher. The discipline is to document every adjustment, not to target a particular percentage.
Who challenges the QoE adjustments - the seller or the buyer?
Both, at different stages. The seller's management challenges the adjustments during the FDD interactions (typically arguing for fewer reductions and more additions). The acquirer's deal team challenges the adjustments after the FDD report (typically arguing for tighter rationale and more conservatism). The QoE bridge survives both challenges because each adjustment is documented and evidenced.
How does the QoE feed into the SPA?
The QoE adjusted EBITDA is the basis for the purchase price calculation. The SPA may also include a 'true-up' mechanism that adjusts the price post-closing if certain items differ from the QoE assumptions. Pro-forma items are sometimes carved out into earn-outs - the acquirer pays additional consideration if the pro-forma assumptions materialise.
