What is a quality of earnings report?

A report by due diligence accountants, usually prepared when a business is being bought or sold, that restates historical earnings to show what the business earns on a repeatable basis. It analyses revenue by customer and month, removes one-off items, tests working capital and reconciles profit to cash. Its adjusted EBITDA often feeds the price and any acquisition debt. It is not an audit, and the firm preparing it normally limits who may rely on it, so a lender checks whether it can.

Is a clean audit opinion enough to rely on reported earnings?

It tells a lender that the accounts meet their reporting framework, which is worth knowing, but it does not address whether the result will repeat. A one-off gain, a sale brought forward or a change in an estimate can all pass audit and still flatter the year. Many smaller borrowers are not audited at all. Either way, the lender carries out its own reading of how much of the profit it can count on.

What are the warning signs of poor earnings quality?

Profit rising while operating cash flow stays flat or falls; debtors or stock growing faster than sales; a cluster of sales at period end; provisions shrinking as the business grows; costs newly capitalised; longer depreciation lives; other income supporting the result; sales to related parties. None proves a problem on its own, since each can have an honest explanation. A lender asks for that explanation and checks whether the pattern holds across several periods.

How can a profitable business have negative cash flow?

Profit is recorded when sales are earned and cash when customers pay. A growing business funds more debtors and stock before the money arrives, and capital spending and loan repayments do not pass through the profit line at all. So growth alone can produce negative operating cash flow for a time. A lender's task is to separate that from the alternative, in which the sales are not collecting or the stock is not selling, because the two call for very different responses.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Quality of Earnings: a Worked Example

Same accounts, same audit opinion, a different lendable number.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

A lender asking about quality of earnings wants to know how much of this year's reported profit will come again next year and arrive as money, because that is the amount debt can be sized on. A clean audit does not settle it: a sale pulled into June, a released provision and wages moved to the balance sheet can all be correctly accounted for and still not repeat. The test takes such items out of EBITDA, walks the reported figure to operating cash flow, and asks whether the balance sheet explains the gap. Leverage, cover and headroom are then read on the lower figure.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// WORK THE SUM

Every Groundwork file that is a number to work out — cash conversion, debt service cover, expected loss, risk-weighted assets, the margin on a bank's own book — with the working shown in the senior read. One minute each, no signup.

Open The Number →

PART OF Credit Analysis for Beginners

// 01 — WHY REPORTED PROFIT IS NOT THE LENDING NUMBER

Accounts record a sale when it is earned and a cost when it is incurred, whatever the bank statement says. That is the right way to measure a year, and it cannot be done without estimates: what the stock is worth, which customers will not pay, what the warranties will cost, how long a machine will last. Each estimate can be reasonable on its own, and each is made by someone with a view about the result.

A lender is repaid over several years, from cash. So it asks two things of a profit figure that the accounts do not have to answer: will it recur, and will it arrive? Profit that will not come again overstates what the business can carry. Profit that stays in debtors, stock or capitalised costs cannot make a loan repayment, however properly it was booked.

The phrase is used at two scales. In a sale or buyout it names a report by due diligence accountants, commissioned by the buyer or the seller, whose adjusted EBITDA is often the figure acquisition debt is sized on. In everyday credit work it names the same question asked by the analyst, from the accounts and the monthly pack.

// 02 — HOW THE TEST RUNS

Sustainable EBITDA = reported EBITDA

− gains and sales that will not repeat

− costs moved out of the profit and loss

+ genuine one-off costs

Operating cash flow = EBITDA − non-cash income − tax paid

− increase in working capital

Cash conversion = operating cash flow ÷ EBITDA

The first walk tests whether the profit will recur, and the second whether it arrives. They use different evidence. Recurrence comes from the notes and the sales ledger: a changed accounting policy, a longer depreciation life, a provision that shrank while sales grew, other income that was not there last year, sales clustered in the last days of the period. Arrival comes from the balance sheet: debtors, stock and capitalised costs growing faster than the sales meant to explain them are where profit waits before it becomes money.

Where one exists, the cash flow statement divides the year's cash into operating, investing and financing activities, and the analyst reads which heading each item was put under. Not every borrower has one. A small UK company reporting under FRS 102 need not prepare it, and smaller private companies in New Zealand and Australia often produce simpler accounts for their owners and the tax authority. The lender then builds the walk from two balance sheets and the profit and loss.

// 03 — THE EXAMPLE

A maker of commercial shelving and racking, constructed for this page like every figure in it, reports EBITDA of US$6.6m, up from US$5.4m, and net debt of US$18.0m. The audit report is clean. Three things happened in the year. In its last week the company shipped US$3.0m of orders due in July, on extended terms, carrying US$0.9m of profit. It released US$0.5m of its warranty provision. And it began capitalising design-team wages, US$0.4m of which would have been an expense last year.

Reported EBITDA 6.6

June shipments pulled forward −0.9

Warranty provision released −0.5

Design wages capitalised −0.4

Sustainable EBITDA 4.8

Net debt ÷ reported: 18.0 ÷ 6.6 = 2.73×

Net debt ÷ sustainable: 18.0 ÷ 4.8 = 3.75×

Nothing here needs to be wrong. The goods were shipped, the provision may really have been too large, and design work can qualify as an asset. But next year starts US$3.0m of orders short, a provision can be released only once, and the designers are still being paid. Leverage is a full turn higher on the figure that can be expected again. Both levels are the example's, not a market norm. Now the cash:

Reported EBITDA 6.6

Warranty release (no cash came in) −0.5

Debtors up (US$3.0m is the June shipments) −3.4

Stock up −1.0

Creditors up +1.2

Tax paid −0.9

Operating cash flow, before interest 2.0

Design wages, shown under investing −0.4

Like for like 1.6

Conversion as reported: 2.0 ÷ 6.6 = 30%

Like for like: 1.6 ÷ 6.2 = 26% (wages expensed)

The two walks meet in the June shipments. The cash from them should arrive next quarter, so part of the weak conversion is timing, and a single year cannot tell timing from trouble. Three years of the same walk can. The wages show why the operating line alone is not enough: moving them to investing lifted operating cash flow by exactly the amount moved.

// 04 — HOW IT DIFFERS FROM AN AUDIT

An audit asks whether the accounts comply with their reporting framework and give a fair picture of the year just ended. It does not say whether the profit will come again, so a clean opinion leaves the lender's question open. The shelving maker's audit could be perfectly sound.

Adjusted EBITDA is the neighbouring figure, and it tends to travel in one direction: the borrower adds back costs it regards as one-off. A quality-of-earnings reading can go either way, and here it takes US$1.8m out. The cash conversion ratio is one measurement inside the test; it would have flagged this year without explaining it. Debtor days do part of the same work on one line of the balance sheet.

DEFINED IN ONE PARAGRAPH → · THE CASH CONVERSION RATIO → · ADJUSTED EBITDA →

// 05 — WHERE IT DECIDES A FILE

The figure a lender accepts sets the size of the debt. On US$4.8m rather than US$6.6m, the same multiple supports about 27% less borrowing, and that difference usually surfaces in the credit paper, well after the borrower has formed a view of what it can raise.

It also decides what a new facility is for. If debtors and stock are absorbing the profit, more working capital finance pays for the absorption without changing it, so the lender first establishes whether the build is growth, timing or something worse. And it reaches the document. A definition of EBITDA that lets a provision release stand counts it in every covenant test whose period includes it, which is why the wording is negotiated, why a lender asks for debtor ageings and monthly figures, and why dividends are read against the cash as well as the profit. The author's book, How Bankers Think, takes the subject further.

CASH FLOW ANALYSIS → · DEBT TO EBITDA →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

IFRS Foundation, IAS 7 Statement of Cash Flows — overview of the standard — The statement classifies a period's cash flows into operating, investing and financing activities, the headings read in section 02 and in the example in section 03.

// QUESTIONS PEOPLE ASK

What is a quality of earnings report?: A report by due diligence accountants, usually prepared when a business is being bought or sold, that restates historical earnings to show what the business earns on a repeatable basis. It analyses revenue by customer and month, removes one-off items, tests working capital and reconciles profit to cash. Its adjusted EBITDA often feeds the price and any acquisition debt. It is not an audit, and the firm preparing it normally limits who may rely on it, so a lender checks whether it can.
Is a clean audit opinion enough to rely on reported earnings?: It tells a lender that the accounts meet their reporting framework, which is worth knowing, but it does not address whether the result will repeat. A one-off gain, a sale brought forward or a change in an estimate can all pass audit and still flatter the year. Many smaller borrowers are not audited at all. Either way, the lender carries out its own reading of how much of the profit it can count on.
What are the warning signs of poor earnings quality?: Profit rising while operating cash flow stays flat or falls; debtors or stock growing faster than sales; a cluster of sales at period end; provisions shrinking as the business grows; costs newly capitalised; longer depreciation lives; other income supporting the result; sales to related parties. None proves a problem on its own, since each can have an honest explanation. A lender asks for that explanation and checks whether the pattern holds across several periods.
How can a profitable business have negative cash flow?: Profit is recorded when sales are earned and cash when customers pay. A growing business funds more debtors and stock before the money arrives, and capital spending and loan repayments do not pass through the profit line at all. So growth alone can produce negative operating cash flow for a time. A lender's task is to separate that from the alternative, in which the sales are not collecting or the stock is not selling, because the two call for very different responses.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit analystReads a borrower and writes the recommendation a decision-maker will act on.
Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
Portfolio managerOwns the credit on a book after the money is out — reviews, covenants, ratings and early warning.

THE IN-TRAY · ONE MINUTE

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A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE CALL · THE LOAN · CAPACITY

A US$35m loan was sized on EBITDA of US$10m. Halfway through the year, management cuts its forecast to US$7m.

What changes?

5 MORE ON THE LOAN · CAPACITY →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHQuality of earnings What does “quality of earnings” mean in credit, and how is it tested?