Quality of Earnings: Why Reported EBITDA May Not Be Maintainable

EBITDA is often the headline financial measure used to market an established business. A seller may describe the business as generating $800,000 of EBITDA and apply an industry multiple to support the asking price.

For a buyer, however, the important question is not simply what EBITDA the business reported. It is how much of that result is sustainable, transferable and likely to convert into cash under new ownership.

A business can report strong EBITDA while depending heavily on its owner, delaying necessary expenditure, relying on one major customer or consuming substantial cash through inventory, receivables and capital expenditure. Seller adjustments can widen the gap further by removing costs that a buyer will still need to incur.

Quality-of-earnings analysis attempts to bridge that gap. It examines how the reported result was produced, identifies items that may not continue and estimates a reasonable range of maintainable earnings.

This is not the same as verifying that the accounts are arithmetically correct. A business may have accurately prepared historical accounts while its future earnings remain materially lower than the headline EBITDA presented to buyers.

What EBITDA shows—and what it does not

EBITDA means earnings before interest, tax, depreciation and amortisation. It can provide a useful starting point for comparing the operating performance of businesses with different financing arrangements, tax positions and asset-accounting policies.

In simplified form:

EBITDA = net profit + interest + tax + depreciation + amortisation

In practice, buyers may encounter several different measures:

statutory or accounts-based EBITDA;
management EBITDA;
adjusted EBITDA;
normalised EBITDA;
broker-presented EBITDA; and
earnings before owner remuneration.

These measures may produce substantially different results.

EBITDA presented outside statutory financial statements is commonly used as non-IFRS financial information. ASIC recognises that non-IFRS information can provide useful insights, but also warns that it can be misleading when its basis, assumptions and reconciliation are not properly explained. ASIC specifically cautions against unexplained “one-off” adjustments, inconsistent exclusions and hypothetical profit figures. ASIC Regulatory Guide 230

EBITDA does not directly show:

cash collected from customers;
changes in receivables, inventory or payables;
maintenance capital expenditure;
taxation payments;
interest and principal repayments;
employee-entitlement liabilities;
debt or equipment-finance obligations;
customer or supplier concentration;
dependence on the owner;
the sustainability of margins; or
the cost of replacing the owner’s work.

For these reasons, EBITDA should not be treated as cash flow available to the buyer.

A business producing $700,000 of EBITDA may require $150,000 of annual equipment expenditure and another $100,000 to support seasonal working capital. Another business producing the same EBITDA may require little additional capital. The two businesses have different cash-generation characteristics and should not automatically receive the same valuation.

Reported EBITDA versus maintainable earnings

Reported EBITDA is a historical accounting measure. Maintainable earnings are an estimate of the operating earnings a reasonably capable new owner could expect under normal conditions.

The calculation usually begins with reported historical earnings and then considers adjustments for:

genuine non-business expenditure;
owner remuneration;
related-party arrangements;
abnormal or non-recurring income and expenses;
underpaid or missing operating costs;
vacant positions;
deferred maintenance;
current trading changes; and
costs required under new ownership.

Maintainable earnings should normally be expressed as a range rather than a single precise figure. The result depends on assumptions about staffing, customer retention, pricing, expenses and operating conditions after settlement.

The analysis should also cover several periods. One strong financial year may not represent the business through an economic cycle or reveal its seasonal working-capital requirements.

Australian Government guidance recommends independently examining three to five years of financial information, including tax returns, Business Activity Statements, receivables, payables, balance sheets, profit and loss statements, cash-flow statements and sales records. Australian Government guidance on buying an existing business

The buyer should seek to reconcile:

statutory or accountant-prepared financial statements;
income-tax returns;
Business Activity Statements;
monthly management accounts;
the general ledger;
payroll records;
sales reports; and
bank-account activity.

Differences are not necessarily evidence of wrongdoing. They must, however, be understood before relying on the earnings figure.

Owner remuneration and discretionary expenses

Owner-related adjustments are common in private-business transactions and are also frequently misunderstood.

An owner may receive:

salary and superannuation;
directors’ fees;
dividends or distributions;
motor-vehicle benefits;
telephone and internet expenses;
travel and accommodation;
insurance;
family-member remuneration; or
other expenditure described as personal.

A genuine personal expense that is recorded in the business and will not continue after the sale may support an add-back. The buyer should verify the amount, confirm that it is not required for the business and ensure that no related cost has been omitted.

Owner remuneration requires more care.

If an owner is paid $200,000 but contributes only limited strategic oversight, a substantial add-back may be supportable. If that owner manages sales, operations, key customers and employees for 60 hours per week, eliminating the salary without including a replacement cost would overstate maintainable earnings.

The analysis should therefore:

identify every function performed by the owner;
estimate the time required for each function;
determine which responsibilities the buyer will personally assume;
identify responsibilities requiring additional employees; and
include market-based remuneration for the replacement resources.

The buyer working in the business without drawing a salary does not make that labour economically free. A valuation based on earnings before reasonable management remuneration can confuse the return on the business with compensation for the buyer’s personal work.

Family-member salaries must also be tested. A family member may be overpaid relative to their duties, creating a possible add-back. Alternatively, they may be underpaid or working unpaid hours, requiring an upward adjustment to future employment costs.

Related-party rent should be compared with the rent payable under the proposed lease. If the seller owns the premises and has charged below-market rent, future earnings may fall once the buyer enters a commercial lease at market rates.

One-off and non-recurring adjustments

A valid adjustment should be identifiable, supported by evidence and unlikely to recur under normal ownership.

Possible examples include:

transaction costs associated with an earlier acquisition;
a discrete legal dispute that has been resolved;
relocation expenses;
a clearly isolated insurance event;
costs of implementing a new system;
an abnormal bad debt linked to a specific event; or
temporary closure caused by an unusual external incident.

The label “one-off” is not enough. Buyers should ask:

What specifically caused the item?
When did it occur?
Is the matter fully resolved?
Has a similar item occurred in earlier years?
Is there any continuing financial effect?
Was related income also received?
Will the buyer incur an equivalent cost after settlement?

Some businesses record restructuring, recruitment, legal, consulting or repair expenses almost every year, even though each individual event is described as exceptional. When different “one-off” expenses recur regularly, an allowance may be required for the recurring pattern.

Adjustments should also be symmetrical. If an abnormal expense is removed, any related insurance recovery, government assistance or other income should also be considered. Buyers should not accept an analysis that removes unfavourable items but retains associated benefits.

Aggressive add-backs

Aggressive add-backs convert a historical result into a hypothetical future result that may never be achieved.

Common examples include:

adding back the owner’s full remuneration without a replacement cost;
removing marketing because the buyer might reduce it;
adding back wages for positions described as unnecessary;
assuming immediate purchasing savings;
including future price increases not yet implemented;
adding anticipated revenue from an unproven pipeline;
removing rent because the buyer may purchase the premises separately;
treating recurring repairs as exceptional;
adding back losses from an underperforming division while retaining its revenue;
excluding a bad month without adjusting the comparison period; and
including “synergies” available only to a specific strategic buyer.

A practical adjustment test is to ask whether the item is:

Historical: Did it actually affect the reported accounts?
Identifiable: Can the amount be traced to underlying records?
Non-recurring: Is there evidence that it will not continue?
Transferable: Will the benefit remain available to the buyer?
Complete: Have all associated costs and benefits been considered?
Independent of the buyer: Does the adjustment reflect the business being acquired rather than a buyer-specific plan?

Future improvements should generally be assessed separately from maintainable earnings. A buyer may be able to increase prices, reduce staffing or negotiate better purchasing terms, but those initiatives require execution and carry risk. The buyer should not normally pay the seller upfront for value that the buyer must create.

Customer and revenue concentration

Quality of earnings concerns the durability of revenue as well as the accuracy of expenses.

A business may report stable EBITDA while becoming increasingly dependent on a small number of customers. If one customer represents 35% of revenue and 50% of gross profit, the loss of that relationship could reduce earnings disproportionately.

Request customer-level analysis showing:

revenue and gross profit by customer;
monthly sales over at least three years;
customer tenure;
retention and churn;
contract expiry dates;
termination rights;
pricing arrangements;
payment history;
recent complaints or service issues; and
whether the relationship depends on the seller.

Revenue concentration should be measured using gross profit as well as sales. A high-revenue customer with a low margin may contribute less to earnings than a smaller customer with attractive pricing.

Contracted revenue also requires examination. A contract may contain termination rights, minimum-volume provisions, price-review mechanisms, change-of-control clauses or assignment restrictions. An order book may include work that customers can cancel or delay.

The buyer should distinguish between:

contracted and committed revenue;
recurring but uncontracted revenue;
repeat project revenue;
one-off projects;
pipeline opportunities; and
management forecasts.

Potential responses to concentration risk may include a lower valuation, staged consideration, an earn-out, a retention condition or other protections developed with professional advisers. The appropriate response depends on the facts and transaction structure.

Deferred expenses and underinvestment

A business can temporarily increase EBITDA by postponing expenditure.

Examples include reducing:

repairs and maintenance;
employee recruitment;
training;
sales and marketing;
insurance coverage;
cybersecurity;
regulatory compliance;
product development;
software upgrades; or
replacement of ageing equipment.

The resulting EBITDA may be historically correct while still being unsustainable. The buyer may need to incur the deferred expenditure shortly after settlement.

Compare each major expense category across several years and against operational activity. Ask why an expense has declined and whether the reduction reflects genuine efficiency or underinvestment.

Employee costs require particular scrutiny. Vacancies, unpaid owner-family labour, excessive overtime or remuneration below the applicable award can understate the sustainable cost base.

The buyer should review employee classifications, awards, agreements, leave balances and payroll records with appropriately qualified advisers. Transfer-of-business rules can affect employee service and entitlements when a business changes ownership. Fair Work Ombudsman guidance

Historical underpayment or non-compliance should not be treated as a source of maintainable earnings. The sustainable cost base should reflect lawful remuneration and realistic staffing requirements.

Working-capital requirements

EBITDA is calculated before changes in working capital.

A profitable business may still consume cash when:

customers take longer to pay;
inventory increases;
work in progress accumulates;
suppliers shorten payment terms;
deposits must be paid in advance; or
growth requires additional operating capital.

Review monthly balances for:

trade receivables;
trade payables;
inventory;
work in progress;
customer deposits;
prepayments;
accrued expenses; and
other operating assets and liabilities.

Year-end balances can be misleading, particularly in seasonal businesses. A retailer may require substantial inventory before Christmas, while a contractor may build work in progress before a major project milestone.

Assess receivables by age rather than accepting the total balance. Old invoices may be disputed or difficult to collect. Inventory should be reviewed for ageing, obsolescence, damage and saleability. Supplier terms should be checked for overdue amounts or arrangements that may change after settlement.

The buyer should estimate a normal level of working capital required to operate the business. This may influence:

the amount delivered at settlement;
the working-capital adjustment mechanism;
the buyer’s initial funding requirement; and
ongoing cash-flow expectations.

A business with increasing EBITDA but deteriorating collections or growing inventory may have lower-quality earnings than the profit and loss statement suggests.

Maintenance capital expenditure

Depreciation and amortisation are excluded from EBITDA, but the cash cost of replacing productive assets is real.

Capital expenditure should be divided into:

maintenance capital expenditure: spending required to sustain current operations; and
growth capital expenditure: spending intended to increase capacity or create new revenue.

Review:

the fixed-asset register;
asset age and condition;
maintenance history;
equipment-finance arrangements;
upcoming replacements;
vehicle condition;
software and technology requirements;
production capacity; and
historical capital expenditure.

A business may operate using fully depreciated equipment that still functions but is approaching the end of its useful life. Low historical depreciation or capital expenditure does not prove that future requirements will remain low.

If maintainable EBITDA is $700,000 but the business requires approximately $120,000 of recurring maintenance capital expenditure, the buyer should not treat the full $700,000 as cash available for debt repayment or distribution.

The estimate does not need false precision at the preliminary stage. A reasonable range based on the asset base, replacement cycle and operating history is more useful than ignoring the requirement entirely.

Seasonality and accounting policies

Annual financial statements can conceal important changes within the year.

Request monthly revenue, gross profit, payroll, operating expenses and EBITDA for at least three years. Compare:

each month with the same month in previous years;
actual results with budgets;
the latest 12 months with complete financial years;
revenue growth with cash collection; and
margins across peak and quieter periods.

This helps identify whether the latest result has been influenced by a strong season, temporary project, unusual timing or deterioration after the financial year-end.

Accounting policies can also affect reported earnings. Review the treatment of:

revenue recognition;
unearned customer income;
project completion;
work in progress;
inventory valuation;
bad-debt provisions;
warranty obligations;
capitalised development or software costs;
provisions and accruals;
leases; and
changes in estimates or accounting methods.

For example, recognising project revenue before the associated work has been completed may bring earnings forward. Capitalising costs that were previously expensed may improve current EBITDA while moving the expense to future periods.

The buyer should identify policy changes and compare results on a consistent basis. Where the accounting is complex or the amounts are material, engage an appropriately qualified accountant to examine the underlying treatment.

Illustrative earnings-reconstruction example

Consider an Australian services business marketed using seller-adjusted EBITDA of $970,000.

The seller’s calculation is:

Seller’s calculation	Amount
Reported EBITDA	$720,000
Add back owner remuneration	$180,000
Add back personal vehicle and travel	$30,000
Add back one-off legal expense	$40,000
Seller-adjusted EBITDA	$970,000

The buyer reviews the adjustments and operating requirements.

The personal expenditure appears genuine and will not continue. The legal matter has been resolved and the expense is adequately supported. However, the owner currently manages operations, major customers and employees. The buyer estimates that a replacement general manager will cost $165,000.

The buyer also identifies reduced marketing expenditure and deferred maintenance that have temporarily supported earnings.

Buyer’s reconstruction	Adjustment	Running EBITDA
Reported EBITDA	—	$720,000
Remove owner remuneration	+$180,000	$900,000
Remove verified personal expenditure	+$30,000	$930,000
Remove supported one-off legal expense	+$40,000	$970,000
Include replacement general manager	−$165,000	$805,000
Restore normal marketing expenditure	−$45,000	$760,000
Include normal repairs and maintenance	−$55,000	$705,000

The buyer’s preliminary maintainable EBITDA is therefore approximately $705,000 rather than $970,000.

The buyer then considers cash requirements outside EBITDA:

Cash-flow consideration	Amount
Preliminary maintainable EBITDA	$705,000
Indicative maintenance capital expenditure	−$75,000
Normal working-capital investment	−$40,000
Indicative cash before tax, financing and transaction expenses	$590,000

If both parties applied a four-times multiple:

Seller-adjusted enterprise value: 4 × $970,000 = $3.88 million
Buyer maintainable-earnings value: 4 × $705,000 = $2.82 million

That is a difference of $1.06 million before considering whether the same valuation multiple is appropriate.

This example is deliberately simplified. A complete analysis would also consider taxation, financing, debt-like liabilities, surplus assets, transaction costs, working capital at settlement and the risks influencing the valuation multiple.

The important point is that a small number of adjustments can materially affect price, financing capacity and buyer returns.

Questions a buyer should ask

A buyer reviewing earnings quality should ask the seller and advisers:

Historical financial information

Can reported EBITDA be reconciled to the financial statements and tax returns?
Can revenue be reconciled to BAS, sales records and bank receipts?
Are monthly management accounts available for at least three years?
Are the accounts prepared on a consistent basis?
Have any accounting policies or estimates changed?
Are the financial statements audited, reviewed or internally prepared?

Earnings adjustments

What is the evidence supporting each add-back?
Has the same type of “one-off” cost occurred in earlier years?
Is any related income being retained while an expense is removed?
Which owner responsibilities must be replaced after settlement?
What is the market cost of those replacement resources?
Are related-party expenses consistent with market terms?
Do the adjusted earnings include buyer-specific synergies or future initiatives?

Revenue quality

Who are the ten largest customers by revenue and gross profit?
How has each major customer traded over the past three years?
What percentage of revenue is contracted, recurring, project-based or one-off?
Are contracts transferable?
Which customer relationships depend on the seller?
Have any significant customers reduced orders or indicated an intention to leave?
How reliable is the current sales pipeline?

Employees and operating costs

Are all required positions currently filled?
Are employees correctly classified and paid?
What employee entitlements may transfer?
Are family members or the owner providing unpaid or underpaid labour?
Has maintenance, recruitment, training or marketing been deferred?
What costs will increase under new ownership?

Working capital and capital expenditure

What normal working capital is required throughout the year?
Are receivables collectable?
Is any inventory obsolete or slow-moving?
Are supplier payments overdue?
What capital expenditure is required during the next three years?
Which assets are leased, financed or subject to security interests?
What expenditure is required merely to maintain current earnings?

A satisfactory answer should be supported by records, not only verbal assurance.

Key takeaway

Quality of earnings is about repeatability, transferability and cash conversion.

The highest EBITDA is not necessarily the best acquisition. A business generating $600,000 of well-supported, diversified and cash-generative earnings may be more valuable than one presenting $900,000 of adjusted EBITDA that depends on aggressive add-backs, one major customer and deferred expenditure.

A disciplined buyer should build a clear bridge from:

Reported earnings → seller adjustments → buyer maintainable earnings → cash available before financing and tax

Every material adjustment should have:

supporting evidence;
a clear reason;
consistent treatment;
an assessment of whether it will recur; and
an explanation of how it affects the business under new ownership.

The purpose is not to produce the most optimistic earnings number. It is to estimate a defensible earnings range that can support valuation, financing and an informed acquisition decision.

This article provides general educational information only. It does not constitute financial product advice, investment advice, legal advice, taxation advice, accounting advice, credit assistance, business-broking advice or a recommendation to acquire any business. Examples are illustrative. Obtain appropriately qualified professional advice and conduct your own investigations before making a transaction decision.