What is a Quality of Earnings (QoE) Report?

Understanding Quality of Earnings Reports

A Quality of Earnings (QoE) report is a third-party financial analysis conducted during M&A due diligence that evaluates the true economic earnings of a target company. Rather than accepting reported financial statements at face value, QoE analysis adjusts for non-recurring items, accounting anomalies, and factors that might distort the company's actual ongoing profitability.

The report answers a fundamental question: are these earnings real, sustainable, and representative of future performance? A company might report $10 million in EBITDA, but QoE analysis might reveal that $2 million came from one-time events, aggressive accounting, or unsustainable practices. The adjusted EBITDA of $8 million represents what buyers can actually expect going forward.

For investment bankers, understanding QoE reports matters because they directly affect deal valuations and negotiations. When transactions are priced as multiples of EBITDA, every dollar of adjustment has a multiplied impact on enterprise value. A $1 million EBITDA adjustment at a 10x multiple means $10 million in valuation change.

Why QoE Reports Matter in M&A

Valuation Impact

Most private company acquisitions are priced using EBITDA multiples. The QoE report determines the adjusted EBITDA that serves as the valuation base. This makes QoE findings among the most consequential elements of due diligence.

Example impact calculation:

Reported EBITDA: $15 million
QoE adjustments: -$2.5 million (non-recurring revenue, understated expenses)
Adjusted EBITDA: $12.5 million
Transaction multiple: 8x
Valuation impact: $20 million reduction (from $120 million to $100 million)

This direct link between QoE findings and purchase price makes the analysis critical for both buyers and sellers.

Risk Identification

Beyond valuation adjustments, QoE reports identify risks that might not appear in headline financials:

Customer concentration that threatens revenue stability
Working capital trends requiring additional investment
Accounting policies that differ from industry norms
Management practices that inflate short-term results
Debt-like items not captured on the balance sheet

These findings inform deal structure, representations and warranties, escrow amounts, and whether to proceed at all.

Deal Certainty

QoE reports reduce information asymmetry between buyers and sellers. Buyers gain confidence that they understand what they're purchasing, while sellers demonstrate transparency that supports their valuation expectations.

Transactions with thorough QoE analysis are less likely to experience late-stage price renegotiations or failed closings. Research indicates that 66% of private equity firms prefer acquiring companies that have already completed sell-side QoE reports.

What QoE Reports Cover

Adjusted EBITDA Analysis

The core of any QoE report is the EBITDA bridge showing how reported earnings translate to adjusted figures. Common adjustment categories include:

Add-backs (increase adjusted EBITDA):

Owner compensation above market rates
One-time professional fees (M&A costs, litigation)
Non-recurring expenses (restructuring, unusual repairs)
Related-party transactions at non-market terms
Discretionary expenses the new owner won't incur

Deductions (decrease adjusted EBITDA):

One-time revenue (insurance recoveries, asset sales)
Revenue recognition timing issues
Understated expenses (deferred maintenance, below-market compensation)
Non-arm's length transactions benefiting the company
Costs that should be capitalized but were expensed

The QoE report documents each adjustment with supporting evidence and quantifies its impact on normalized earnings.

Revenue Quality Assessment

QoE analysis examines whether reported revenue is sustainable and recurring:

Customer concentration: What percentage comes from top customers? High concentration creates risk if key relationships change.
Contract terms: Are revenues contractually committed or at-will? Long-term contracts provide more visibility.
Revenue recognition: Are policies appropriate and consistently applied? Aggressive recognition can pull forward future revenue.
Backlog and pipeline: What visibility exists into future revenue? Strong backlogs support projections.
Pricing trends: Are prices stable, increasing, or under pressure? Margin sustainability depends on pricing power.

Understanding revenue quality helps buyers assess whether historical performance will continue post-acquisition.

Working Capital Analysis

The QoE report analyzes net working capital (NWC) requirements and establishes the appropriate level to be delivered at closing:

Historical NWC trends and seasonality
Normalized NWC level (the "peg" or "target")
Components requiring adjustment (aged receivables, obsolete inventory)
Cash conversion cycle analysis
Unusual items affecting working capital timing

Working capital targets directly affect the closing cash payment. If actual NWC at closing falls below the target, the purchase price adjusts downward, and vice versa.

Debt and Debt-Like Items

QoE reports identify obligations that function like debt even if not classified as traditional borrowings:

Capital leases and financing arrangements
Deferred revenue requiring future performance
Accrued liabilities and reserves
Unfunded pension obligations
Contingent liabilities and guarantees
Deferred compensation arrangements

These items reduce the equity value buyers receive and must be considered in transaction structuring.

Proof of Cash

A critical QoE procedure is reconciling reported earnings to actual cash flows. Proof of cash analysis verifies that reported revenue actually generated cash collections and reported expenses actually required cash payments.

Discrepancies between earnings and cash flows can reveal:

Revenue recognition issues
Expense timing manipulation
Balance sheet irregularities
Potential fraud indicators

This analysis provides fundamental assurance about financial statement integrity.

Understanding how the three financial statements link helps you appreciate why proof of cash analysis is so important for validating reported earnings.

Get the complete guide: Download our comprehensive 160-page PDF covering M&A concepts, valuation frameworks, and technical questions tested in investment banking interviews. Access the IB Interview Guide for complete preparation.

Buy-Side vs. Sell-Side QoE

Buy-Side QoE Reports

Traditionally, QoE analysis was conducted by buyers during due diligence after signing a letter of intent. The buyer engages an accounting firm to analyze the target's financials and identify issues affecting valuation or deal structure.

Buy-side QoE characteristics:

Commissioned and paid for by the buyer
Conducted during exclusivity period (typically 30-60 days)
Focuses on identifying risks and validating seller claims
Findings may support price renegotiation
Serves the buyer's interests in the transaction

Sell-Side QoE Reports

Increasingly, sellers commission their own QoE reports before going to market. Sell-side QoE has become standard for middle-market transactions and provides several advantages:

Seller benefits:

Identify and address issues before buyers discover them
Support asking price with third-party validation
Accelerate due diligence by having analysis ready
Reduce deal uncertainty and renegotiation risk
Demonstrate professionalism and transparency

Process benefits:

Shortens buyer due diligence timelines
Reduces information requests during exclusivity
Provides consistent narrative across multiple bidders
Limits ability of buyers to use findings for price chips

Sell-side QoE reports are typically shared in the data room after buyers sign NDAs, complementing the CIM with detailed financial analysis.

When to Use Each Approach

Sell-side QoE is most valuable when:

Running a competitive auction process
Expecting multiple sophisticated buyers
Financials have complexity requiring explanation
Seller wants to control the narrative
Transaction size justifies the investment

Buy-side only may suffice when:

Single buyer in a negotiated transaction
Buyer has strong existing knowledge of the target
Straightforward financials with limited adjustments
Time pressure prevents pre-marketing analysis

Who Prepares QoE Reports

Typical Providers

QoE reports are prepared by accounting firms and financial advisory practices specializing in transaction services. Provider selection depends on transaction size and complexity:

Large transactions (>$100 million): Big Four accounting firms (Deloitte, PwC, EY, KPMG) and large regional firms with dedicated transaction advisory practices.

Middle-market transactions ($25-100 million): Regional accounting firms, boutique transaction advisory firms, and Big Four middle-market practices.

Smaller transactions (<$25 million): Local CPA firms with M&A experience, boutique advisory firms, and specialized QoE providers.

Cost Considerations

QoE report costs vary significantly based on scope and complexity:

Small companies (<$10 million revenue): $15,000-40,000
Mid-sized companies ($10-50 million revenue): $40,000-75,000
Larger middle-market ($50-250 million revenue): $75,000-150,000+

Private equity buyers often prefer reports from recognized regional or national firms, viewing provider quality as a signal of report reliability.

Limited Scope Options

For smaller transactions or specific situations, limited scope QoE reports focus on particular areas rather than comprehensive analysis:

EBITDA adjustments only (no working capital or debt analysis)
Specific time period rather than full historical analysis
Targeted procedures addressing known concerns
Desktop review versus full fieldwork

Limited scope reports cost less and take less time but provide narrower assurance. They're most appropriate for smaller deals or preliminary analysis before committing to full diligence.

Common QoE Findings

Red Flags That Affect Deals

Certain QoE findings commonly lead to price adjustments or deal restructuring:

Revenue quality issues:

Significant customer concentration (>20% from single customer)
Declining contract renewal rates
Channel stuffing or aggressive revenue recognition
One-time project revenue presented as recurring

Expense manipulation:

Deferred maintenance creating future liabilities
Below-market owner compensation
Related-party transactions at favorable terms
Capitalization of expenses that should be expensed

Working capital concerns:

Aged receivables suggesting collection problems
Obsolete or slow-moving inventory
Unusual payables stretching
Seasonal patterns not reflected in peg

Control weaknesses:

Lack of formal accounting policies
Inadequate documentation for transactions
Related-party transactions without proper approval
Inconsistent application of accounting standards

How Findings Affect Negotiations

QoE findings influence deal terms in several ways:

Purchase price adjustments: Direct EBITDA impacts flow through to valuation using the transaction multiple.

Earnouts: If revenue sustainability is questioned, portions of purchase price may become contingent on future performance.

Escrows and holdbacks: Identified risks may require seller funds held in escrow pending resolution.

Representations and warranties: Specific findings generate targeted reps that allocate risk to the seller.

Deal structure: Significant issues might shift deals from asset purchases to stock purchases, or require additional protections.

Understanding how private equity firms evaluate acquisitions helps contextualize why QoE findings matter so much to financial sponsors.

QoE in the Deal Process

Timing in M&A Transactions

QoE analysis typically occurs after LOI signing but before definitive agreement:

Pre-marketing (sell-side QoE):

Seller engages QoE provider 2-3 months before launch
Analysis completed before buyer outreach
Report included in data room for serious buyers

Due diligence (buy-side QoE):

Buyer engages QoE provider after signing LOI
Analysis conducted during 30-60 day exclusivity period
Findings inform final negotiations and definitive documents

Typical timeline:

Kick-off and information request: Week 1
Fieldwork and analysis: Weeks 2-4
Draft report and management discussion: Week 4-5
Final report delivery: Week 5-6

Integration with Other Due Diligence

QoE is one component of comprehensive due diligence. It integrates with:

Legal due diligence: Contract review informs revenue sustainability; litigation review affects contingent liabilities.

Operational due diligence: Business understanding supports revenue and cost normalization judgments.

Tax due diligence: Tax positions affect cash flows and may require additional reserves.

IT due diligence: System capabilities affect financial reporting reliability and integration planning.

QoE providers coordinate with other advisors to ensure comprehensive coverage without duplication.

Master interview fundamentals: Practice 400+ technical and behavioral questions covering M&A analysis, due diligence, and valuation concepts. Download our iOS app for comprehensive interview prep with AI-powered feedback.

Interview Relevance

QoE concepts appear in investment banking interviews when discussing due diligence or demonstrating practical deal knowledge.

Common Questions

"What is a Quality of Earnings report?" Explain that it's a third-party financial analysis validating reported earnings by adjusting for non-recurring items, accounting anomalies, and factors that distort true ongoing profitability. Emphasize that adjusted EBITDA from QoE analysis typically serves as the valuation base.

"What are common EBITDA adjustments?" Discuss add-backs (owner compensation, one-time expenses, non-recurring costs) and deductions (one-time revenue, understated expenses, timing issues). Give specific examples relevant to private company transactions.

"Why does QoE matter for valuations?" Explain the direct math: EBITDA adjustments multiply through the transaction multiple to affect enterprise value. A $1 million adjustment at 8x means $8 million in valuation impact.

"What's the difference between buy-side and sell-side QoE?" Cover timing, who pays, and strategic purpose. Note that sell-side QoE is increasingly common as sellers seek to control the narrative and accelerate due diligence.

Demonstrating Deal Awareness

Understanding QoE reports shows interviewers you know how deals actually work beyond theoretical concepts. Strong candidates can discuss:

Where QoE fits in the transaction timeline
How findings affect negotiations and deal structure
Why adjusted EBITDA matters more than reported figures
The relationship between QoE and valuation multiples

This practical knowledge distinguishes candidates with genuine deal exposure or thorough preparation.

Key Takeaways

A Quality of Earnings report is a third-party analysis that adjusts reported earnings for non-recurring items to determine true ongoing profitability
QoE findings directly affect deal valuations because transactions are typically priced on adjusted EBITDA multiples
Reports cover EBITDA adjustments, revenue quality, working capital, debt-like items, and proof of cash
Sell-side QoE reports are increasingly standard, helping sellers control the narrative and accelerate due diligence
Common findings include customer concentration, revenue recognition issues, deferred maintenance, and working capital anomalies
QoE analysis typically costs $15,000-150,000+ depending on company size and scope
Findings influence not just price but also earnouts, escrows, representations, and deal structure
Understanding QoE demonstrates practical deal knowledge valued in investment banking interviews

Conclusion

Quality of Earnings reports serve as the financial truth serum of M&A transactions. By stripping away one-time items, accounting choices, and presentation decisions, QoE analysis reveals what a company actually earns on a sustainable basis.

For investment bankers, understanding QoE matters because these reports directly determine the numbers that drive valuations. When you're building a DCF or applying multiples, the quality of your inputs determines the quality of your outputs. QoE analysis ensures that the EBITDA you're valuing represents economic reality rather than accounting artifacts.

Whether you're preparing for interviews or beginning your banking career, recognizing QoE's role in due diligence demonstrates the practical deal knowledge that distinguishes strong candidates. The concepts are straightforward, but their application in live transactions shows sophisticated understanding of how M&A actually works.