Quality of Earnings (QoE): Why Buyers Commission It and Sellers Should Prepare
The quality of earnings report has become the centrepiece of financial due diligence. Where founders see their EBITDA, buyers see a number that requires validation. The QoE report provides that validation, transforming reported financials into a normalised view of sustainable earnings that determines what buyers are willing to pay.
Understanding what a QoE report examines, why buyers rely on it, and how to prepare for its findings separates sellers who achieve their target valuations from those who watch price erode during diligence.
What Quality of Earnings Actually Measures
A quality of earnings analysis examines whether reported financial performance reflects the sustainable, recurring earnings capacity of the business. It strips away noise, one-time events, and accounting choices to reveal what the company actually earns from its core operations.
The output is normalised EBITDA: earnings before interest, taxes, depreciation, and amortisation, adjusted to reflect ongoing operations rather than historical peculiarities. This normalised figure, not the reported figure, becomes the basis for valuation.
Consider the typical adjustments. Owner compensation above market rate gets normalised to what a replacement would cost. One-time legal settlements, insurance recoveries, or extraordinary expenses are excluded. Related party transactions are scrutinised for market-rate pricing. Revenue recognition timing is examined for sustainability.
The analysis is designed to answer a fundamental question: if I buy this business and run it normally, what will it actually earn?
Why Buyers Commission QoE Reports
Buyers face a structural information disadvantage. Sellers know their businesses intimately; buyers see only what is disclosed. The QoE report corrects this imbalance by providing independent verification of financial claims.
For private equity buyers in particular, QoE has become non-negotiable. Industry data indicates that approximately 90% of PE-backed transactions utilise quality of earnings analysis. The report satisfies both the sponsor's own diligence requirements and the documentation demands of lenders providing acquisition financing.
The analysis supports valuation decisions. Most M&A valuations derive from EBITDA multiples. If reported EBITDA differs from normalised EBITDA, the implied valuation changes proportionally. A business valued at 5x EBITDA trades at a materially different price depending on whether that EBITDA is $2M or $1.7M.
QoE reports also identify risks that affect deal structure. Working capital requirements, revenue concentration, and expense sustainability all emerge from the analysis. These findings shape not just price but escrows, earnouts, and representation and warranty provisions.
What the Analysis Examines
Quality of earnings analysis encompasses several key areas, each designed to validate different aspects of financial performance.
Revenue Quality
For recurring revenue businesses, the analysis examines whether reported revenue reflects sustainable customer relationships or temporary factors. Analysts look at customer cohorts, churn patterns, expansion dynamics, and concentration risk.
Key questions include: What percentage of revenue comes from the largest customers? How has retention evolved over time? Are expansion revenues from existing customers or unsustainable one-time sales? Does the revenue recognition policy align with industry standards?
EBITDA Adjustments
The heart of QoE analysis is identifying and quantifying EBITDA adjustments. These fall into several categories:
Non-recurring items. One-time expenses or revenues that will not repeat under new ownership. Legal settlements, restructuring costs, and unusual gains or losses belong here.
Owner-related adjustments. Compensation, benefits, and perquisites that exceed market rates for the roles performed. Personal expenses run through the business. Family members on payroll who perform no function.
Related party transactions. Payments to affiliated entities or individuals that may not reflect arm's-length pricing. Rent to a property owned by the founder. Services from a company controlled by a family member.
Pro forma adjustments. Changes that have already been made but not yet fully reflected in historical results. A recently added revenue stream, a cost reduction initiative already implemented, or headcount changes not yet annualised.
Working Capital Analysis
Working capital, the capital required to fund day-to-day operations, affects how much cash the buyer must leave in the business. The QoE analysis establishes a normalised working capital target and identifies seasonal or cyclical patterns that affect requirements.
Disagreements about working capital are common sources of post-LOI adjustment. Sellers who understand their working capital dynamics before diligence can anticipate these discussions.
Expense Sustainability
Analysts examine whether current expense levels are sustainable or whether they represent unsustainable cuts or temporary investments. A business that has reduced marketing spend to boost short-term margins may face questions about customer acquisition sustainability. One investing heavily in growth may deserve credit for expenses that will normalise at scale.
The Valuation Impact
Quality of earnings directly affects transaction value. Research from GF Data analysing 360 transactions found that sellers who commissioned sell-side QoE reports achieved average TEV/EBITDA multiples of 7.4x, compared with 7.0x for those who did not undertake a QoE process. That 0.4x differential represents meaningful value on any meaningful EBITDA base.
The benefits appear most pronounced in larger transactions, where the complexity of financial analysis increases and buyer scrutiny intensifies. For deals with enterprise values above $50 million, the valuation lift from sell-side preparation becomes particularly significant.
Perhaps more importantly, sell-side QoE accelerates transaction timelines. The same research indicates that over 90% of the time, having a sell-side report moves deals faster than they would have proceeded otherwise. In transactions where time kills deals, this acceleration has value beyond any multiple improvement.
The Case for Sell-Side QoE
Traditionally, QoE reports were commissioned by buyers during diligence. The seller would wait to see what issues emerged, then respond reactively. This approach puts sellers at a disadvantage.
Sell-side quality of earnings inverts this dynamic. By commissioning your own analysis before going to market, you identify issues proactively, prepare responses, and address fixable problems before buyers discover them.
Consider the difference in positioning. A seller who presents a QoE report alongside their marketing materials demonstrates financial transparency and operational sophistication. Issues are disclosed with context and explanation rather than discovered by hostile analysis. The narrative remains in the seller's control.
Despite these benefits, adoption remains incomplete. While approximately 90% of PE-backed deals involve sell-side QoE, only about 50% of founder-led lower middle market businesses commission the analysis. This gap represents an opportunity for prepared sellers to differentiate themselves.
Timing and Process
Sell-side QoE should begin three to six months before the formal sale process launches. This timing provides adequate runway to identify issues, implement fixes, and allow improved practices to generate historical data.
The analysis itself typically requires 30 to 45 days, depending on data availability and business complexity. Faster turnaround is possible when management can supply information promptly and respond to analyst questions efficiently.
Expect significant management involvement. Finance teams will spend considerable time extracting data, explaining variances, and responding to questions. This investment pays dividends when buyer diligence begins, as your team will already be familiar with the questions and prepared with answers.
Cost Considerations
Quality of earnings reports represent meaningful expense. Costs vary by deal size and complexity, with lower middle market transactions typically falling in the $20,000 to $75,000 range for sell-side analysis. Larger or more complex situations command higher fees.
The economics generally favour the investment. A 0.4x multiple improvement on $2M EBITDA represents $800,000 in additional enterprise value. Even accounting for uncertainty in the research and variability across transactions, the expected return on a $50,000 QoE investment compares favourably to most alternatives.
Beyond direct valuation impact, sell-side QoE reduces deal risk. Transactions that proceed with fewer surprises close more reliably. Broken deals have costs, both direct and opportunity, that dwarf diligence preparation expenses.
Preparing for the Analysis
Whether you commission sell-side QoE or prepare for buyer analysis, several steps improve outcomes.
Clean your financials. Ensure your books accurately reflect business reality. Reconcile accounts, clear outstanding items, and document unusual transactions. The cleaner your starting point, the smoother the analysis.
Document your adjustments. If you believe certain items warrant normalisation, document your reasoning and supporting evidence. Proactive documentation of legitimate adjustments is far more credible than reactive justification.
Understand your working capital. Know your working capital cycle, seasonal patterns, and normalised requirements. This understanding helps you anticipate discussions and push back on unreasonable targets.
Prepare your team. Finance personnel will face detailed questions during the analysis. Ensure they understand the process, have time allocated for support, and know what information they can share.
Address fixable issues. If you know issues exist, such as related party transactions at non-market rates or personal expenses in the business, address them before analysis begins. Problems fixed are better than problems explained.
The Buyer's Perspective
Understanding what buyers seek from QoE analysis helps sellers prepare more effectively.
Buyers want confidence that reported performance reflects reality. They want to understand what the business will actually earn under their ownership. They want to identify risks that require structural protection or price adjustment.
Sellers who provide this confidence through transparent, well-documented financials and proactive analysis create smoother processes and better outcomes. Those who resist scrutiny or appear surprised by their own financials raise exactly the questions that erode valuations and extend timelines.
Quality of earnings has become the standard of financial diligence. Sellers who embrace this reality and prepare accordingly position themselves for success. Those who treat it as an obstacle to overcome often discover that their resistance becomes the problem buyers remember.
If you are preparing for a transaction and want to discuss QoE timing and approach, we are happy to share our perspective.