Quality of Earnings
A quality of earnings report is the buyer's financial due diligence on what a business really earns: an accountant's analysis of the seller's EBITDA that strips out one-offs, tests the adjustments management has added back, checks revenue against contracts and cash, and sets the working capital and net debt figures the price will be adjusted on. The number it produces — normalised, run-rate EBITDA — is the one the multiple is applied to.
- Also known as
- QoE, Quality of earnings report, QoE analysis
- Used at
- confirmatory due diligence in almost every acquisition above a few million; often also by sellers, as a sell-side QoE before a process starts
- Binding
- no — an adviser's report addressed to the buyer (or seller); the sale agreement's price adjustments and warranties are where its findings become binding
- Typical scope
- the last two to three years and the trailing twelve months; revenue by customer and product; margin; adjustments to EBITDA; working capital by month; net debt and debt-like items; the quality of the forecasts
- Typical cost and time
- $50,000–300,000 and four to eight weeks, scaled to the target; the sell-side version is paid by the seller and shared with bidders
- Parties
- the buyer, its accountants, the target's finance team and auditors, and the seller's advisers, who argue every adjustment
How a quality of earnings report works in practice
The seller presents adjusted EBITDA: reported EBITDA plus add-backs — the owner's above-market salary, a legal settlement, a discontinued product, "non-recurring" costs. The QoE team tests each: was the settlement really one-off, or does the company get sued every year; is the salary add-back matched by the cost of a replacement manager; is the discontinued product's cost gone but its revenue still in the base. It then adds its own adjustments the seller did not volunteer: revenue recognised early, a customer that has given notice, a price rise that will not repeat, costs capitalised that should have been expensed.
It reads the revenue the way a fintech buyer needs it read: recurring against one-off, contracted against usage, by customer and by cohort; for a payments company, take rate by merchant and the concentration in the top ten. It rebuilds working capital month by month to set the target the price will be adjusted against at completion, and lists debt-like items — deferred revenue, accrued bonuses, unpaid tax, a regulatory reserve — that reduce the cash the seller receives.
The output is a bridge from reported to normalised EBITDA and a list of the things the buyer should price, protect with a warranty, or walk away from.
Example
A fintech's seller presents adjusted EBITDA of €7.0m: reported €5.2m plus €1.8m of add-backs. The QoE agrees €0.9m (an owner's salary above market, a one-off office move), rejects €0.6m (a "non-recurring" bad debt that recurs every year at a similar size), and finds €0.7m the seller did not mention: €0.4m of revenue from a customer that served notice in the last quarter and €0.3m of software development capitalised at a rate the auditors had queried. Normalised EBITDA is €5.4m. At the 8× multiple in the letter of intent, the price moves from €56m to €43.2m; the buyer also sets the working capital target at €2.1m against the seller's proposed €1.4m, and lists €1.1m of debt-like items. The seller's adviser recovers €0.2m of the adjustments in negotiation, and the deal signs at €45m.
Common mistakes
- Sellers presenting add-backs they cannot document, which cost credibility on the ones they can. - Buyers pricing on the seller's adjusted EBITDA and doing the QoE afterwards, so every finding is a renegotiation. - Treating the QoE as an audit; it tests earnings quality, not the existence of every balance. - Ignoring the working capital analysis, where the last €1m of price is usually won or lost. - For a fintech, a QoE that reads revenue in total and never by merchant, cohort or take rate.