What is Quality of Earnings? And Why It Can Make or Break Your Deal

Selling a business is rarely a straightforward transaction. Between discussions on price, negotiation over terms, and careful evaluation of operations, there’s one critical concept that often catches sellers off guard: Quality of Earnings (QoE).

At its core, the quality of earnings report is the buyer’s way of kicking the tires—not just on how much profit the business claims to earn, but how reliable, sustainable, and transferable that profit really is. The distinction may seem subtle, but the implications can be significant. Buyers aren’t just buying a number—they’re buying what that number represents. And the QoE is how they test the strength of that foundation.

In this article, we’ll break down what a quality of earnings report includes, why it matters so much in the context of a business sale, and what sellers can do to prepare for it in advance.

What Is “Quality of Earnings”?

When buyers look at your business, they’re looking beyond revenue or even bottom-line net income. They want to understand how the business earns money, whether those earnings are repeatable, and what the real cash flow will look like once they’re at the helm.

A quality of earnings report, typically conducted by a third-party accounting or advisory firm, dives deep into your company’s financials to answer those questions. The goal is to validate the economic reality of your earnings—adjusting for anything that may not be sustainable, recurring, or relevant post-transaction.

Unlike a basic financial audit, which is about compliance and historical accuracy, a QoE analysis is forward-looking and transactional in nature. It helps the buyer see what they’re truly buying.

What Does a QoE Report Include?

A full QoE report can vary in scope, but here are some of the most common components:

1. EBITDA Normalization
   Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is often used as a proxy for cash flow in deal negotiations. A QoE report works to “normalize” EBITDA by removing:

   • One-time revenues or expenses

   • Owner-related discretionary expenses

   • Non-operational income or costs

   • Unusual accounting treatments or timing issues

2. Revenue Quality
   Is your revenue recurring or project-based? Are there any concentration risks (e.g., one customer making up 40% of sales)? The QoE assesses how reliable and diversified the top line truly is.

3. Working Capital Analysis
   Understanding trends in accounts receivable, payable, and inventory helps buyers assess the short-term cash needs of the business post-close—and how much working capital needs to be left in the business.

4. Customer and Contract Review
   Buyers want to know if customer relationships are formalized through contracts, and whether those contracts are transferable. They also evaluate churn rates, renewal terms, and dependencies.

5. Cash vs. Accrual Accounting
   If your business uses cash-based accounting, the QoE may adjust the financials to reflect an accrual basis. This can surface hidden liabilities or mismatches between revenue recognition and cost timing.

6. Revenue Recognition Practices
   Are you recognizing revenue when it's earned, or when it's received? The QoE will analyze your policies to determine whether earnings reported align with economic activity.

Why Buyers Rely on QoE Reports

If a buyer is going to put millions of dollars on the line, either personally or with the support of a lender or investor, they’re going to want to know what they’re really getting. QoE reports provide assurance. Here’s why they matter:

• Lenders require it.
  If the buyer is using bank financing (as is common in small and mid-sized deals), the lender will typically mandate a QoE review before releasing funds.

• Buyers want to avoid surprises.
  A thorough analysis reduces the risk of post-closing disappointments—things like inflated margins, hidden expenses, or revenue cliffs.

• It supports valuation confidence.
  If your business is truly performing well, a QoE helps substantiate your asking price. But if there are issues under the hood, they’re better uncovered early, before the deal unravels at the eleventh hour.

• It helps structure the deal.
  Buyers use QoE findings to negotiate deal terms, from purchase price to working capital targets and earn-out provisions.

How a QoE Can Affect Valuation

This is where things get real. Let’s say your business reports $1 million in EBITDA, and you're expecting a 5x multiple—that’s a $5 million sale price.

Now imagine the QoE report identifies $200,000 in adjustments:

• $100,000 in one-time consulting revenue

• $50,000 in owner personal expenses run through the business (which you thought added back, but were already partially included)

• $50,000 in unusually low maintenance costs that were deferred

Suddenly, adjusted EBITDA drops to $800,000. At a 5x multiple, that’s a $1 million hit to enterprise value. The number itself hasn’t changed—but the quality of the number has.

Common Issues That Trigger Adjustments

While every deal is different, here are a few patterns that often lead to significant adjustments in QoE reviews:

• Customer concentration: Relying too heavily on one or two accounts can lower earnings quality.

• Aggressive revenue recognition: Booking sales before they’re earned or delivering product/service too slowly.

• Overstated margins: Either through deferred maintenance, aggressive cost capitalization, or underreporting COGS.

• Unrecorded liabilities: Pending refunds, warranties, or legal expenses that haven’t been fully accounted for.

• Discretionary expenses: These are often tricky—what qualifies as “add-back” versus a true operating expense depends on the buyer’s perspective and consistency.

Preparing for a QoE: What Sellers Can Do Now

If you’re even thinking about selling in the next 6–24 months, it’s worth preparing for a QoE review early. Here’s how:

1. Get your books clean
   Switch to accrual accounting if you haven’t already. Keep owner expenses well documented. Be ready to explain any inconsistencies.

2. Document add-backs clearly
   If you’re running personal expenses through the business, keep detailed records. Add-backs are only accepted if they’re provable and non-recurring.

3. Invest in accounting help
   Bringing in a CPA familiar with transaction prep can be a smart investment. They can help you preempt QoE findings and clean up financials proactively.

4. Consider a sell-side QoE
   Some sellers choose to commission their own QoE report before going to market. While not always necessary, this can build buyer confidence and reduce surprises.

Final Thoughts: Transparency Wins

Buyers know that no business is perfect. What they want is clarity—an honest picture of how the business performs, where the risks lie, and what the cash flow will look like moving forward.

The quality of earnings process doesn’t have to be adversarial. In fact, when approached with transparency and preparation, it can actually help the deal move faster and build trust with the buyer. It’s not just about proving a number—it’s about showing that your business is healthy, sustainable, and worth investing in.

If you're contemplating a sale, don't think of QoE as a hurdle. Think of it as your opportunity to demonstrate the real value you've built.