Quality of Earnings Reports: What They Are and How to Prepare
Understanding the cornerstone of PE financial due diligence.
Key Takeaways
- •QoE reports validate revenue quality, normalize EBITDA, and identify financial risks
- •Sellers should conduct their own sell-side QoE to identify issues before buyers do
- •Issues discovered proactively cost less than issues discovered during buyer diligence
- •QoE analysis typically takes 3-6 weeks and costs $50K-$150K for mid-market deals
A Quality of Earnings (QoE) report is the centerpiece of financial due diligence in PE transactions. Conducted by accounting firms, QoE analysis validates the seller's financial representations and identifies risks that could affect valuation or deal structure.
Understanding QoE—and preparing for it proactively—can mean the difference between a smooth transaction at full value and a troubled deal with price reductions and extended timelines. A fractional CFO can help you prepare your financials before the QoE process begins.
What QoE Reports Analyze
QoE goes far beyond audited financial statements. While audits confirm GAAP compliance, QoE analysis examines the underlying quality and sustainability of earnings.
Core Analysis Areas
Revenue Quality
Is revenue recurring or one-time? Are there unusual revenue recognition practices? What's the customer concentration risk? Are there channel stuffing or pull-forward concerns? How does contract backlog support projections?
EBITDA Normalization
What adjustments are appropriate to reflect ongoing earnings power? Which add-backs are legitimate vs. aggressive? What's the normalized run-rate EBITDA? How does adjusted EBITDA compare to reported figures?
Working Capital
What's the normalized working capital required to operate the business? Are there seasonal patterns? What's the appropriate "peg" for the transaction? Are receivables and inventory properly valued?
Debt and Debt-Like Items
What liabilities transfer to the buyer? Are there off-balance sheet obligations? Deferred revenue concerns? Underfunded benefits? Pending litigation or tax exposure?
Common QoE Adjustments
QoE analysis typically results in adjustments to reported EBITDA. These can be additive (increasing EBITDA) or negative (decreasing EBITDA).
Typical Add-backs (Increase EBITDA)
- Above-market owner compensation
- Non-recurring professional fees
- One-time litigation or settlement costs
- Personal expenses run through business
- Related party transactions above market
Typical Deductions (Decrease EBITDA)
- Below-market owner compensation
- Deferred maintenance or CapEx
- Non-recurring revenue included in baseline
- Understaffing that will need correction
- Revenue recognition timing issues
Red Flags QoE Analysts Look For
QoE analysts are trained to identify patterns that suggest earnings may not be sustainable or that financial reporting may be aggressive.
Common Red Flags
The Value of Sell-Side QoE
Smart sellers conduct their own QoE analysis before going to market. This "sell-side QoE" identifies issues before buyers find them, allowing you to address problems or prepare explanations proactively.
Why Proactive Discovery Matters
An issue you identify and explain costs far less than an issue a buyer discovers. When buyers find problems during diligence, they have leverage—they can demand price reductions, escrow holdbacks, or indemnification. When you surface the same issue upfront with context and explanation, it's simply part of the story.
Sell-Side QoE Benefits
- Identify issues early: Time to address problems before going to market
- Support valuation: Documented adjustments strengthen your position
- Accelerate diligence: Organized materials speed buyer analysis
- Maintain credibility: Demonstrates financial sophistication
- Reduce surprises: Buyers finding new issues derails deals
Typical Costs and Timeline
| Deal Size (EBITDA) | Sell-Side QoE Cost | Timeline |
|---|---|---|
| $2M-$5M | $30K-$60K | 3-4 weeks |
| $5M-$10M | $50K-$100K | 4-5 weeks |
| $10M+ | $75K-$150K+ | 5-6 weeks |
How to Prepare for QoE
Preparation for QoE should begin 6-12 months before you plan to go to market.
QoE Preparation Checklist
Related Resources
Need Help Preparing for QoE?
Eagle Rock CFO helps companies prepare for Quality of Earnings analysis. We identify issues before buyers do and help you present your business in the best possible light.
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