Quality of earnings (QoE) is an analysis of whether a business’s reported profit is accurate, recurring, and backed by cash. A QoE report, usually prepared by an accounting firm for a buyer or lender, starts from the seller’s numbers and removes anything that will not continue under new ownership. The output is an adjusted earnings figure (adjusted EBITDA or SDE) that you can price the deal on.
Quality of earnings vs. an audit
| Audit | Quality of earnings | |
|---|---|---|
| Question | Are the financial statements fairly stated under accounting rules? | What will this business really earn for a new owner? |
| Who orders it | The company, often for lenders or investors | Usually the buyer, sometimes the seller before a sale |
| Output | A formal opinion | Adjusted earnings, a list of adjustments, and risks |
| Focus | Historical accuracy | Sustainability and cash |
What a quality of earnings report checks
- Proof of cash. Revenue ties to bank deposits month by month.
- Revenue quality. Recurring vs. one-time revenue, customer concentration, and trends by product or location.
- Normalization adjustments. Owner compensation brought to market rates, personal expenses removed, one-time items tested.
- Pro forma adjustments. Costs that will change after closing, such as rent under a new lease or a manager to replace the owner.
- Net working capital. A normal level of receivables, inventory, and payables, which sets the working capital target in the purchase agreement.
- Debt-like items. Deferred revenue, unpaid taxes, customer deposits, and other obligations that should reduce the price.
Do you need a QoE for a small business?
A QoE is a paid engagement, and its fee scales with the size and complexity of the deal. On larger acquisitions, many buyers and lenders treat it as required. On a small, simple business, many buyers rely on their own review plus the lender’s underwriting. Either way, a QoE normally comes after the LOI, once you have a deal worth paying for. You still need a way to decide which deals deserve an LOI.
How to run a first-pass quality of earnings check
- Tie the P&L to the tax returns for each year. Explain any gap in gross receipts.
- Tie revenue to bank deposits for at least 12 months. Include card-processor statements for retail and service businesses.
- List every add-back and ask for support. Remove any “one-time” cost that appears in more than one year.
- Check margins by year. A sudden jump in gross margin in the sale year deserves questions.
- Get revenue by customer. Compute the share of the largest customer and the top five.
- Replace the owner. If you will hire a manager, deduct a market salary from SDE to see what is left for debt and for you.
- Look for debt-like items: customer deposits, prepaid services, deferred maintenance, and unpaid taxes.
Common quality of earnings adjustments in small deals
| Adjustment | Direction | Why |
|---|---|---|
| Recurring “one-time” repairs | Reduces earnings | A cost that happens every year is an operating cost. |
| Owner pay below market | Reduces earnings | You will pay a manager market rates. |
| Rent below market (seller owns building) | Reduces earnings | Your lease will be at market rent. |
| Personal expenses in the business | Increases earnings | Only with records. |
| Lost customer or contract | Reduces earnings | Revenue that will not continue. |
FAQ
Is a quality of earnings report the same as a business valuation?
No. A QoE tells you what the business really earns. A valuation applies a multiple or other method to earnings. A good valuation needs good earnings first; see how to value a business.
Who pays for the quality of earnings report?
Usually the buyer, because the buyer relies on it. Some sellers order one before going to market to support their price; buyers should still test it.
Is a Deal Readout memo a QoE?
No. It is a first-pass review from the documents you upload. It finds the issues fast and tells you what a QoE or your own diligence must confirm.