Quality of Earnings Report

The primary purpose of a QoE is to determine whether the seller's reported or adjusted EBITDA accurately reflects the company's ongoing earnings power. The report examines revenue quality (is it recurring or one-time?), expense normalization (are costs being understated?), working capital trends, and customer concentration risk. A QoE also identifies the appropriate level of normalized working capital, which becomes the 'peg' or target for the working capital adjustment in the purchase agreement.

QoE analysts scrutinize every add-back and adjustment the seller makes to arrive at adjusted EBITDA. Common adjustments include removing one-time legal settlements, normalizing owner compensation to market rates, adding back non-recurring consulting or transaction costs, and adjusting for revenue timing differences. Importantly, the QoE often identifies adjustments the seller did not make — such as above-market related-party transactions or aggressive revenue recognition policies — which reduce the true EBITDA figure.

Several patterns signal earnings quality concerns: a widening gap between EBITDA and operating cash flow, aggressive revenue recognition (booking revenue before delivery), heavy reliance on add-backs that exceed 25-30% of reported EBITDA, customer concentration where one client represents more than 20% of revenue, and declining gross margins masked by cost-cutting. A QoE that reveals materially lower EBITDA than the seller represented often leads to purchase price renegotiation or deal termination.

The QoE directly influences the final purchase price because the deal is typically structured as a multiple of trailing EBITDA. If the QoE reduces adjusted EBITDA by $2M and the deal multiple is 8x, the implied purchase price drops by $16M — illustrating the leverage of enterprise value multiples. The QoE also establishes the normalized working capital target used in the purchase agreement's closing mechanism. Sellers increasingly commission their own sell-side QoE before going to market to preempt buyer adjustments and maintain negotiating leverage.