Quality of Earnings: What Buyers Actually Look For in a Mid-Market Deal

Most mid-market sellers discover the difference between reported profit and defensible profit somewhere around week three of diligence. The buyer’s advisers have rebuilt three years of monthly EBITDA, stripped out items the owner considered ordinary, and produced a number that is materially lower than the one on which the letter of intent was priced. The negotiation that follows is rarely about whether the business is good. It is about whether the earnings are real, recurring and transferable.

A quality of earnings (QoE) analysis is the instrument that settles that question. It is not an audit. An audit asks whether the financial statements are free from material misstatement under an accounting framework. A QoE asks a narrower and more commercial question: what is the sustainable earnings base a buyer is actually acquiring, and what does the balance sheet have to look like on day one for that earnings base to be achievable?

What a QoE analysis actually tests

Every QoE reduces to four tests applied relentlessly across the analysis period, usually the trailing thirty-six months plus a trailing twelve months (TTM) view to the most recent month-end.

• Is it real? Does the revenue correspond to goods delivered or services performed, evidenced by cash collection and third-party documentation?
• Is it recurring? Will the earnings persist under new ownership, or do they depend on a one-time event, a departing customer, or a relationship the seller personally holds?
• Is it transferable? Does the cost base reflect what the business will actually cost to run post-close, including costs the owner has absorbed personally or through related entities?
• Is it complete? Are there liabilities, commitments or deferred costs that have not landed in the P&L yet but will?

The output is an EBITDA bridge — a schedule that walks from statutory or book EBITDA to adjusted EBITDA, line by line, with each adjustment supported by evidence a third party can inspect. In practice the bridge, not the report narrative, is the document that gets negotiated.

How the workstream runs

From trial balance to a monthly databook

The analysis starts with monthly trial balances, not annual financial statements. The provider maps every general ledger account to a standardised P&L and balance sheet, then produces a monthly databook covering revenue by customer, product and geography; gross margin by the same cuts; and operating expenses by natural class. Monthly granularity is what exposes seasonality, cut-off manipulation and step changes in cost that annual figures conceal.

Proof of cash

A proof of cash reconciles recorded revenue and expenses to bank statement movements for each month. It is the single most effective test for fictitious or prematurely recognised revenue, because a receipt either cleared the bank or it did not. Unreconciled differences that persist month after month — particularly in businesses with heavy cash sales, distributor rebates or agency collections — are treated as a scope issue rather than a rounding matter.

Revenue analytics and customer concentration

Buyers look for the composition of growth, not just its rate. A useful decomposition splits year-on-year revenue movement into price, volume, mix, new customers, lost customers and expansion within retained customers. A business growing at 20 per cent on the back of two new logos is priced differently from one growing at 12 per cent on net expansion across two hundred accounts. Concentration thresholds vary by sector, but a single customer above roughly 15–20 per cent of revenue will usually trigger a specific diligence request and, frequently, a deferred consideration structure.

Working capital and net debt

The final workstream is balance-sheet side: a normalised working capital analysis to set the completion peg, and a net debt schedule to identify debt-like items. These two schedules move the purchase price directly, rupee for rupee, and are discussed further below.

The adjustment taxonomy

Adjustments fall into recognisable families. The table below sets out the ones that appear most often in mid-market transactions, the treatment a buy-side team will typically propose, and the evidence a seller should be ready to produce.

Two principles govern the argument. First, an add-back must be both non-recurring and outside the normal course; a cost that recurs every year in different guises is not a one-off. Second, adjustments cut both ways. A credible sell-side analysis includes the negative normalisations, because a bridge containing only favourable items destroys the seller’s credibility on the favourable ones too.

Red flags that change the shape of a deal

• Gross margin that improves while price and mix are flat. Usually inventory capitalisation, deferred cost or under-accrued rebates.
• A fourth-quarter or March revenue spike that reverses in the first weeks of the new year. Channel stuffing or cut-off pushing, visible in the sales return rate and in credit notes issued after period end.
• Receivable days rising faster than revenue. Either collection weakness or revenue recorded against arrangements that customers have not accepted.
• Round-sum journals at period end, posted by senior finance staff. A standard forensic filter is manual journals above a value threshold posted outside business hours or to unusual account combinations.
• Related-party balances that never settle. Persistent intercompany or director current-account positions frequently mask funding, leakage or undisclosed obligations.
• Statutory dues carried long past due date. Unpaid GST, TDS, provident fund or ESI liabilities are debt-like, attract interest and penalty, and in India can also carry director-level consequences.
• Free cash flow that does not track EBITDA. Over three years, cumulative EBITDA and cumulative operating cash flow should converge unless there is a structural working capital or capex explanation. Divergence is the single most useful summary indicator.

Working capital pegs and debt-like items

In a locked-box or completion-accounts structure, purchase price is typically equity value = enterprise value − net debt +/− working capital versus a normalised target. The target, or peg, is usually set as an average of normalised monthly working capital over the trailing twelve months, adjusted for seasonality and for anything already treated as debt.

The contested items are almost always the same: deferred revenue and customer advances, accrued employee benefits including gratuity and leave encashment, deferred capex and retention money, unpaid statutory dues, factored or discounted receivables, and any related-party balance. Each one a buyer succeeds in reclassifying from working capital to net debt reduces the price at completion. Sellers who arrive with a documented position on each item, prepared before the process starts, concede far less ground.

How a seller should prepare

Preparation is mostly a matter of doing the buyer’s work first, in a controlled environment, six to twelve months before going to market.

1. Close the books properly, monthly. A hard close by working day ten with supported schedules removes the largest single source of diligence friction.
2. Build the EBITDA bridge yourself. Document each proposed adjustment with the evidence attached at the time, not reconstructed under pressure.
3. Clean up related-party arrangements. Settle current accounts, put leases and management contracts on written, arm’s-length terms.
4. Reconcile revenue to GST returns and to bank. Differences between GSTR-1, GSTR-3B, e-invoicing data and books are among the first analytics a buy-side team runs on an Indian target.
5. Fix the balance sheet. Write off dead inventory and uncollectable receivables before the process, when the earnings impact can be explained, rather than during it, when it looks like a discovery.
6. Assemble a data room with a defined structure. Contracts, statutory registers, employee data, tax assessments and litigation status, indexed and complete.
7. Commission a vendor-side QoE where the deal warrants it. It converts surprises into disclosed positions and shortens exclusivity.

The economics favour preparation. A single contested adjustment on a business earning meaningful EBITDA, at a mid-single-digit multiple, moves headline value by several times the cost of the diligence exercise that would have anticipated it.

What the report should tell you

A QoE report worth reading is short on adjectives and long on schedules. It should contain the EBITDA bridge, the monthly databook, the proof of cash, the working capital analysis with a recommended peg, the net debt schedule with each debt-like item argued, a customer and supplier concentration analysis, and a clear statement of scope limitations. Where the data did not support a conclusion, it should say so rather than smoothing the gap.

Artham Fintech supports both buy-side and vendor-side quality of earnings work for mid-market transactions, including the underlying monthly rebuild, working capital and net debt analysis, and readiness preparation for owners planning a sale. If a transaction is on your horizon and you would like a view on where your reported earnings are likely to be challenged, we are happy to discuss the specifics.