Every add-back is a claim about the future
A target reports EBITDA of $80m. The seller's deck reports adjusted EBITDA of $119m. Same year, same business. The $39m between them is four adjustments, and each one is a claim about what next year will look like. Quality of earnings is the discipline of testing those claims.
Quality of earnings asks how faithfully reported earnings describe the business, and how much of them will persist or turn into cash you can use. It looks at revenue timing, estimates, recurring costs, adjustments, customer concentration and financing needs. It is not one ratio, and it is not an audit opinion. The reflex is evidence: what supports each number, and what would change it?
Normalize symmetrically
The $80m includes a $12m litigation settlement, documented and one-off; $18m of recurring stock compensation; $9m of restructuring, for the third year running; and a $7m gain on unused land. The seller adds back the three expenses and keeps the gain: 80 + 12 + 18 + 9 = $119m. The analyst adds back the settlement and removes the gain: 80 + 12 − 7 = $85m. Unusual gains leave the normalized view on the same terms as unusual costs.
The recurring costs stay in until the evidence says otherwise. Stock compensation pays people who will need paying next year too. A restructuring that happens every year is a running cost with a fresh name each time. Repeated "one-time" charges are a pattern, and a pattern is recurring.
- $12m litigation settlement: documented, one-off, added back
- $7m gain on unused land: not operating, taken out
- $18m stock compensation: recurring pay
- $9m restructuring: third consecutive year
An add-back does not refund the cash
Normalizing the settlement out does not put the $12m back. Show it in the cash analysis, check whether similar litigation recurs, and ask what the land sale says about the assets left to sell. An add-back is an analytical choice, not proof the item never mattered. This is a Scorecard (income statement) adjustment; the Cash Ledger (cash flow statement) still shows the payment.
A strong conclusion says which earnings belong to ordinary operations, which estimates are uncertain, what cash obligations remain and what evidence could change the view. There is no rule that every unusual or noncash item comes out. Each one is argued on its own.
Reported EBITDA is $80m, including a $12m one-off settlement expense and a $7m one-off gain on a land sale. A symmetric normalization gives what?