Why Quality of Earnings Matters More in a Selective M&A Market

Purchase price discussions in the middle market are often framed around a multiple of EBITDA. The simplicity of that calculation can obscure one of the most important questions in a transaction: what is the appropriate EBITDA to which that multiple should be applied?

The answer is rarely as straightforward as taking operating income and adding back interest, taxes, depreciation, and amortization.

Privately held businesses frequently contain expenses, revenue items, or accounting practices that may not reflect the company's expected economics following a transaction. These can include owner compensation above or below market levels, personal or discretionary expenses, one-time professional fees, unusual litigation costs, nonrecurring revenue, start-up costs associated with new locations, or other items management believes are not representative of ongoing operations.

Identifying these items is relatively easy. Demonstrating that they are legitimate adjustments is considerably more important.

One of the most common areas of disagreement during financial due diligence is the treatment of EBITDA adjustments.

Sellers naturally want buyers to understand earnings without the effect of unusual or nonrecurring costs. Buyers, however, must determine whether those costs will actually disappear after closing.

Consider a company that incurred $500,000 of expenses related to an unsuccessful expansion initiative. Management may characterize the entire amount as nonrecurring. A buyer may agree with the characterization but still ask several questions: Was the expense truly isolated? Have similar expenses occurred historically? Will additional costs be incurred after closing? Did the initiative generate revenue that also needs to be removed from the analysis?

These questions illustrate an important principle of quality of earnings: an adjustment should be supported by the underlying economics of the business, not simply by how an expense is labeled in the general ledger.

The importance of normalized EBITDA becomes even clearer when viewed through the lens of valuation.

Assume a business reports $5.0 million of EBITDA and is valued at an 8.0x multiple. That implies an enterprise value of approximately $40 million.

If financial due diligence identifies $500,000 of sustainable EBITDA adjustments, normalized EBITDA increases to $5.5 million. At the same multiple, the implied enterprise value becomes approximately $44 million.

Conversely, if diligence determines that $500,000 of management's proposed adjustments are unsupported, the same valuation framework can move in the opposite direction.

This is why disagreements over seemingly modest adjustments can become significant transaction issues.

A quality of earnings analysis should not be viewed simply as an exercise in calculating adjusted EBITDA.

A well-executed analysis helps buyers and sellers understand the broader financial characteristics of the business, including revenue growth and composition, customer concentration and retention, gross margin trends, recurring versus nonrecurring revenue, historical EBITDA adjustments, working capital requirements, cash-to-accrual accounting considerations, potential debt-like items, and changes in the underlying cost structure.

Together, these analyses help answer a more fundamental question: how much of the company's historical earnings are reasonably expected to continue after the transaction closes?

For business owners considering a sale, the best time to address quality of earnings issues is often before a buyer begins diligence.

Reviewing financial results in advance can provide an opportunity to identify unusual accounting treatments, reconcile financial information, document potential EBITDA adjustments, understand working capital trends, and resolve inconsistencies before they become transaction issues.

Just as importantly, preparation allows management to develop a credible financial narrative supported by data rather than attempting to explain adjustments for the first time during buyer diligence.

In a competitive process, that preparation can improve credibility, reduce surprises, and help maintain transaction momentum.

The 2026 M&A market demonstrates that transaction activity and transaction selectivity can exist at the same time.

Buyers continue to deploy capital, but they are increasingly focused on businesses with durable earnings and financial information that can withstand scrutiny. For sellers, presenting a credible view of normalized EBITDA can therefore be just as important as generating EBITDA in the first place.

For buyers, quality of earnings provides something equally valuable: a clearer understanding of what they are actually paying for.

In either case, the objective of financial due diligence should not simply be to validate the numbers. It should be to understand the economics behind them.