Glossary
Quality of Earnings (QoE)
A quality of earnings (QoE) analysis is a financial diligence review that tests whether a company's reported and adjusted earnings are accurate, recurring and sustainable. It reconciles financial statements to bank and tax records, evaluates EBITDA adjustments, and analyzes revenue, margins and working capital to support valuation and financing decisions.
Example
A seller presents adjusted EBITDA of $5,000,000. The QoE review rejects $400,000 of add-backs that recur every year and finds $200,000 of revenue recognized before the related work was performed. Diligence-adjusted EBITDA is $5,000,000 - $400,000 - $200,000 = $4,400,000. At an 8.0x multiple, implied value falls from $40,000,000 to $35,200,000, a $4,800,000 difference that the buyer can use to renegotiate price or structure.
How it is used in underwriting
QoE is standard in middle market M&A and increasingly common in smaller deals. Buyers commission it to validate the price they agreed in the letter of intent; lenders often require it before funding acquisition debt; and sellers sometimes order a sell-side QoE to reduce surprises. A typical report covers proof of cash (matching revenue to bank deposits), adjusted EBITDA bridges, revenue by customer and product, gross margin trends, net working capital and its seasonal pattern, debt and debt-like items, and accounting policy issues such as revenue recognition, accruals and capitalization of costs.
A QoE is not an audit. It does not issue an opinion on financial statements, but it is usually more focused on the questions that drive price: is the earnings base real and will it continue? Findings commonly lead to purchase price reductions, a higher working capital peg, specific indemnities, escrows or earnouts. The working capital analysis is often as valuable as the EBITDA work because it sets the peg. For smaller acquisitions financed with SBA loans, a lighter QoE or proof of cash review can still catch the most common problems, including unsupported add-backs and cash revenue gaps.
Frequently asked questions
What is included in a quality of earnings report?
A QoE report typically includes an adjusted EBITDA bridge, proof of cash reconciling revenue to bank deposits, revenue and customer analysis, margin trends, net working capital analysis to support the peg, a review of debt and debt-like items, and observations on accounting policies such as revenue recognition and accruals.
Is a quality of earnings report the same as an audit?
No. An audit provides an opinion on whether financial statements follow accounting standards. A QoE is a diligence analysis focused on the sustainability of earnings and the issues that affect price, such as add-backs, customer trends and working capital. Many companies with audited statements still undergo a QoE before a sale.
When should a seller get a sell-side QoE?
A seller may commission a sell-side QoE before going to market to identify issues early, support the asking price and speed up buyer diligence. It is most useful when financials are unaudited, add-backs are significant or the business has complex revenue recognition. Buyers usually still perform their own review.
Related terms
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