The buyer does not acquire a P&L. The buyer acquires the economic engine that produced it. And the economic engine may be materially different from the P&L that represents it.
Reported EBITDA of Rs 120 crore sounds compelling. But Rs 15 crore of that came from a one-time contract that will not repeat. Rs 8 crore came from a provision release established in a prior year. Rs 6 crore came from capitalising development costs that the buyer’s accounting policies would expense. Rs 4 crore came from a change in depreciation method that reduced the annual charge. And Rs 3 crore came from revenue recognised on a contract with contingent terms where the contingency has not yet been resolved.
Sustainable EBITDA, after adjusting for these items, is approximately Rs 84 crore. The buyer who pays 10x on reported EBITDA pays Rs 1,200 crore. The buyer who pays 10x on sustainable EBITDA pays Rs 840 crore. The difference, Rs 360 crore, is the cost of not performing a quality-of-earnings analysis.
This is not fraud. Every item above is within accounting standards. The seller has reported accurately. But the buyer inherits economics, not reported EBITDA. And the economics, once the non-recurring items roll off, the provisions cannot be released again and the accounting policies are harmonised, produce a very different earnings stream from the one the management presentation showed.
The Normalisation Methodology
Non-recurring revenue
Identify every revenue item that will not repeat in the next period: asset sales, insurance recoveries, contract termination payments, one-time project revenue, catch-up billing from prior periods, revenue from a customer that has already indicated it will not renew.
Each item is removed from sustainable earnings. The adjusted revenue figure represents what the business can generate from its ongoing commercial relationships and operational activities.
Non-recurring costs
Identify every cost item that is genuinely one-off: restructuring costs, litigation settlements, impairment charges, transaction costs (legal, advisory, due diligence fees for the current deal), natural disaster costs, one-time regulatory penalties.
Each item is added back to sustainable earnings. But the add-back must be genuine: a “restructuring cost” that appears every year for five years is not non-recurring. A “one-time” marketing campaign that recurs under different labels each year is not one-time. The forensic discipline is in distinguishing between items that are genuinely exceptional and items that management labels as exceptional to inflate adjusted earnings.
Accounting-policy adjustments
Where the target’s accounting policies differ from the buyer’s (or from the most neutral treatment), restate the earnings under the buyer’s policies. Capitalised development costs are expensed. Extended useful lives are shortened to industry median. Aggressive revenue recognition is restated to the point of delivery. Under-provisioned expected credit losses are increased to reflect historical default rates.
The accounting-policy adjustment reveals how much of the reported performance is operational and how much is presentational.
Owner-related costs
In promoter-led companies, the cost structure frequently includes items that benefit the promoter rather than the business: above-market compensation, personal expenses charged to the company, family members on the payroll, vehicles, travel and entertainment that serve personal rather than business purposes.
These costs are added back to sustainable earnings because they will not continue under new ownership. The add-back represents the true operating cost of the business under market-standard management.
Customer economics
The quality of revenue depends on the quality of the customers who generate it. Revenue from customers with high churn risk, deteriorating credit quality, declining purchase volumes, or concentrated in a single relationship is lower-quality than revenue from diversified, sticky, creditworthy customers.
The QoE analysis assesses customer quality through cohort analysis (are customer cohorts expanding or contracting?), retention rates (is the customer base stable?), concentration (how much revenue disappears if the top three customers leave?) and credit quality (are the customers who owe the most also the ones most likely to default?).
What Survives After the Deal
The QoE analysis answers a single question: of the reported EBITDA, how much will the buyer actually earn in Year 1 post-close, under the buyer’s own accounting policies, without the non-recurring items, without the owner benefits and with a realistic assessment of customer durability?
The answer is the sustainable earnings base: the economic engine the buyer is actually acquiring. Everything above it is a temporary benefit that the seller captured and the buyer paid for but will not receive.
In Northrop Management Private Limited’s due diligence practice, the QoE analysis is the foundational workstream of every financial diligence engagement. It determines the adjusted earnings base to which the valuation multiple is applied, and it is therefore the single analysis with the largest direct impact on the purchase price.
Ashish Chaudhary, frames the diligence principle directly: “The buyer inherits economics, not reported EBITDA. The difference between the two is the quality-of-earnings adjustment, and for most mid-market transactions, that adjustment ranges from 10% to 30% of reported EBITDA. A buyer who does not perform this analysis is paying a multiple on earnings that include items they will never receive.”
Questions for the Boardroom
- What is the gap between our target’s reported EBITDA and our calculated sustainable EBITDA?
- How many of the “non-recurring” items in the management presentation have occurred more than once in the last five years?
- If we restated the target’s earnings under our own accounting policies, how would EBITDA change?
- What owner-related costs are embedded in the target’s cost structure, and what is the total add-back?
- What is the customer-quality assessment: are the target’s customers expanding, stable or contracting?
Closing Implication
Quality of earnings is not a technical adjustment. It is the translation of reported performance into economic reality. The reported EBITDA is what the seller presents. The sustainable EBITDA is what the buyer will earn. The gap between the two is the risk that the buyer is paying for performance that will not persist, and closing that gap is the single most valuable exercise in any due diligence engagement.
