What is Quality of Earnings?

The financial due diligence process that verifies a company's historical earnings and validates management's EBITDA adjustments.

Key Takeaways

  • •QoE validates whether reported earnings are sustainable and recurring
  • •Performed by independent accounting firms during M&A due diligence
  • •Analyzes revenue quality, expense normalization, and working capital
  • •Can result in purchase price adjustments or deal structure changes

Quality of Earnings Definition

A Quality of Earnings (QoE) report is a detailed financial analysis performed during M&A due diligence. It verifies whether a company's reported earnings are accurate, sustainable, and truly representative of ongoing business performance.

Unlike an audit (which confirms financial statements follow accounting rules), a QoE goes deeper: it asks whether those numbers represent real, repeatable cash generation that a buyer can rely on.

QoE vs. Audit

Audit

  • Did they follow GAAP?
  • Are the numbers accurate?
  • Historical focus

Quality of Earnings

  • Are earnings sustainable?
  • Are adjustments reasonable?
  • What should a buyer expect?

What a QoE Report Analyzes

Revenue Quality

  • Is revenue recognition appropriate?
  • Are there one-time or non-recurring revenues?
  • Customer concentration risk?
  • Contract terms and renewal rates?
  • Revenue trends by customer, product, geography?

EBITDA Adjustments

  • Validation of owner add-backs
  • Non-recurring expense identification
  • Related party transaction analysis
  • Pro forma adjustments (if applicable)
  • Normalized run-rate EBITDA calculation

Working Capital

  • Normalized working capital target
  • Seasonality and cyclicality
  • AR aging and collectability
  • Inventory valuation and obsolescence
  • AP terms and timing

Other Analysis

  • Net debt calculation
  • Capital expenditure requirements
  • Deferred revenue analysis
  • Off-balance sheet liabilities
  • Tax exposure review

Why Quality of Earnings Matters

Risk Mitigation

Buyers identify issues before closing rather than after. Prevents overpaying for a business based on inflated earnings.

Price Validation

QoE confirms the EBITDA used to calculate purchase price. Adjustments directly impact valuation.

Deal Structure

Findings inform earn-out structures, holdbacks, representations and warranties, and other deal terms.

Integration Planning

QoE reveals operational realities that inform post-acquisition integration and synergy planning.

Common QoE Adjustments

QoE analysts frequently adjust for these items:

Often Validated (Add-Backs)

  • Owner compensation above market
  • One-time professional fees
  • Non-recurring legal costs
  • Owner personal expenses through business
  • Related party rent above market

Often Rejected/Reduced

  • "One-time" expenses that recur annually
  • Understaffing (cost savings from vacancies)
  • Deferred maintenance
  • Aggressive revenue recognition
  • Synergy projections without basis

Adjustment Impact

If you're selling at 5x EBITDA and the QoE reduces adjusted EBITDA by $200,000, that's a $1 million reduction in purchase price. Every adjustment matters.

How to Prepare for a QoE

Sellers can take steps to ensure a smooth QoE process:

  • Clean up your books: Resolve reconciliation issues, clear old items, ensure accurate categorization
  • Document adjustments: Create a detailed schedule with supporting evidence for every add-back
  • Organize a data room: Have financial statements, contracts, and supporting documents ready
  • Identify issues first: Better to disclose problems proactively than have them discovered
  • Consider sell-side QoE: Getting your own QoE before going to market can accelerate deals
  • Prepare management: Ensure key team members understand the process and can answer questions

Frequently Asked Questions

How much does a Quality of Earnings report cost?

QoE reports typically cost $15,000-$50,000 for small to mid-sized businesses, depending on complexity. Larger transactions or complex businesses may cost $75,000+. The cost is usually borne by the buyer for buy-side QoE, or the seller for sell-side QoE. Given that QoE adjustments often represent 5-15% of purchase price, the investment is usually worthwhile.

Should sellers get their own QoE report?

A sell-side QoE is increasingly common and offers several advantages: identify and fix issues before going to market, pre-emptively address buyer concerns, demonstrate credibility, and potentially support a higher valuation. It can also speed up the due diligence process since buyers see you've already been vetted.

What happens if the QoE finds problems?

Common outcomes include: price reduction (buyers adjust the offer based on true earnings), deal restructuring (earnouts, seller notes), additional representations and warranties, or deal termination in serious cases. Minor adjustments are normal; material issues (fraud, undisclosed liabilities) are deal-killers.

How long does a QoE analysis take?

Typically 2-4 weeks for straightforward businesses, longer for complex situations. The timeline depends on document availability, business complexity, and responsiveness. Having a well-organized data room can significantly accelerate the process.

Related Terms & Resources

EBITDA

The earnings metric QoE validates

Due Diligence Checklist

All documents buyers request

EBITDA Adjustment Worksheet

Document your add-backs properly

Fractional CFO for M&A

CFO support for transactions

Preparing for Due Diligence?

A fractional CFO can help you prepare for a QoE process, document adjustments, and present your business in the best light.

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