One of the most common misconceptions I hear from business owners is that a Quality of Earnings (QoE) report is simply an accounting exercise that happens late in the sale process.
In reality, a Quality of Earnings review can have a significant impact on valuation, deal structure, and your negotiating leverage.
If you’re considering selling your business, you can avoid surprises well into a transaction by understanding how buyers use QoE reports and why an independent sell-side QoE can be advantageous.
What Is a Quality of Earnings Report?
Let’s start with a simple definition: a Quality of Earnings report is a financial diligence process designed to evaluate the sustainability and accuracy of a company’s earnings.
At a high level, buyers want to answer a simple question:
Are the earnings being presented today a reliable indicator of future cash flow?
The report goes far beyond reviewing a profit and loss statement. It analyzes how revenue is recognized, how expenses are recorded, whether earnings have been adjusted appropriately, and whether there are risks hidden beneath the surface of the financial statements.
Most sophisticated buyers, particularly private equity firms, will conduct a Quality of Earnings review after signing a Letter of Intent (LOI). In many cases, their lenders require it.
In other words, if you’re selling your company, you probably won’t avoid the process. The question is whether you’ll be prepared for it.
Why Buyers Focus So Heavily on Quality of Earnings
Many middle-market businesses operate on cash-basis accounting because it’s simple and often advantageous from a tax perspective.
There’s nothing inherently wrong with that.
The challenge is that buyers evaluate businesses differently than owners do.
Buyers want to understand earnings on an accrual basis because it provides a clearer picture of economic performance.
For example:
- A company might prepay six months of inventory or supplies in December to reduce taxable income.
- A healthcare practice might recognize revenue only when insurance payments are received rather than when services are performed.
- A project-based business may receive payments at times that don’t align with when work is actually completed.
None of these situations are unusual. However, they can create significant differences between cash-basis earnings and the earnings a buyer ultimately uses to value the company.
A strong QoE process also examines the underlying drivers of revenue and profitability. Depending on the business, the review may analyze:
- Customer concentration
- Referral concentration
- Payer mix
- Collection effectiveness
- Revenue by location
- Revenue by provider or producer
- Vendor relationships
- Technology investments
- Operational dependencies
The objective is to identify risks that could affect future performance.
For example, a potential risk might be that one customer represents 35% of revenue or that a single physician generates a disproportionate share of collections. Or maybe a business has significantly underinvested in cybersecurity, technology, or infrastructure compared to industry peers.
Buyers consider these examples risks because they’re buying both historical earnings and future cash flow.
The Quality of Earnings process helps them assess how durable that future cash flow is likely to be.
The EBITDA Adjustment Conversation
One of the primary goals of a QoE report is determining what the company’s “normalized” EBITDA really is.
This is where discussions can often become contentious.
Owners may have legitimate expenses that won’t continue after a transaction. Examples might include:
- One-time legal expenses
- Extraordinary consulting costs
- A major website rebuild
- Personal expenses run through the business
- Owner-specific perks or discretionary spending
These are commonly referred to as add-backs. When properly supported, add-backs can increase adjusted EBITDA and therefore increase value.
However, not every adjustment is accepted automatically.
Buyers will scrutinize each add-back and ask whether the expense is truly non-recurring or whether it represents an ongoing cost of operating the business.
The Reality About Buy-Side Quality of Earnings
Buyers frequently describe QoE work as a confirmatory exercise, which technically is true. Though practically speaking, it’s also one of the few opportunities they have to revisit assumptions made during the bidding process.
If a buyer’s Quality of Earnings analysis concludes that EBITDA is lower than expected, you can expect that finding to become part of the valuation discussion. On the other hand, if the analysis suggests earnings are stronger than originally projected, it’s less likely to result in an increased purchase price.
That’s why sellers should understand that QoE isn’t simply a box-checking exercise. It can materially influence the economics of a deal.
Why a Sell-Side Quality of Earnings Can Be Valuable
This is one area where I often see business owners gain leverage by being proactive.
Rather than waiting for a buyer’s diligence team to identify issues, sellers can commission a sell-side Quality of Earnings report before going to market.
Doing so provides several advantages:
- Identify potential issues before buyers do.
- Support your EBITDA adjustments with credible third-party analysis.
- Frame the financial discussion using the same lens buyers and lenders will ultimately apply.
- Reduce the likelihood of unpleasant surprises after an LOI is signed.
Nothing creates deal friction faster than discovering material issues during diligence that could have been identified months earlier.
Final Thoughts
Quality of Earnings reports have become a standard part of middle-market M&A, designed to help buyers understand exactly what they’re purchasing.
The challenge for sellers is that the process often uncovers issues that directly impact value.
That said, the best way to protect yourself isn’t to avoid the scrutiny, but to prepare for it. The earlier you understand how buyers will evaluate your earnings, the stronger your position will be when it comes time to negotiate.
And in many cases, that preparation can mean the difference between defending your valuation and watching it get negotiated downward during diligence.
If you are thinking about a sale this year, next year, or further down the road, Caber Hill Advisors can help you understand where your business stands today and what buyers will want to see before they make an offer. Let’s talk about your future.
