A Quality of Earnings (QoE) report can help build the trust needed between buyers and sellers during a merger and acquisition (M&A) deal. They can also help recapitalizations, minority investments, or private equity transactions move forward without a hitch. A QoE report looks beyond surface-level financial data and gets to one question:
How sustainable are the earnings of the company, and what should a buyer or seller understand before a deal is put into motion?
When people refer to “deal risk,” they are not usually referring to anything terribly complicated. More often than not, it is simply a matter of whether the financial narrative is clean, consistent, and repeatable, or if some aspect of the earnings needs to be adjusted or clarified.
What “Deal Risk” Means in Plain English
In an M&A deal, “risk” is ultimately a question of uncertainty.
For example:
- Are profits driven by normal business activity, or by unusual events?
- Do profits look steady from month to month, or do they fluctuate wildly?
- Are there unusual expenses or missing expenses that affect what the earnings really are?
- Does this business need more working capital than it appears to need?
The QoE report isn't assuming something is wrong; it's assuming that uncertainty is what needs to be reduced, so both parties can make better decisions and move forward with the deal.
What Is a Quality of Earnings Report?
A Quality of Earnings (QoE) report is an independent financial analysis that evaluates how reliable and sustainable a company’s earnings really are.
Unlike standard financial statements, a QoE report looks beyond reported profits to identify what portion of earnings comes from normal, repeatable business operations versus one-time or non-recurring items.
A QoE report will typically involve an in-depth review of:
- Normalized earnings, typically focusing on EBITDA
- Revenue and margin trends
- Expense structure and staffing
- Key Balance Sheet Items
- Working capital requirements
A QoE report isn’t an audit. An audit results in an independent opinion on whether the financial statements are presented fairly, in all material respects, under the applicable accounting framework. A QoE is built for the deal; it helps buyers understand what earnings are made of and how sustainable and repeatable they're likely to be after the transaction.
Limitations of a QoE Report
It’s important to note that a QoE report is not a substitute for a full audit and does not provide assurance that financial statements are presented in accordance with GAAP or any other framework. The analysis relies on the quality and completeness of information provided by management, and normalizing adjustments are inherently subjective. QoE reports are focused on historical data and may not fully capture future risks or opportunities. Additionally, the scope of a QoE engagement is typically defined by the client and may not cover all areas of potential risk or concern. Users should be aware of these limitations when relying on a QoE report for decision-making.
5 Main Focus Areas of a Quality of Earnings Report
While every deal is unique, most QoE reports address a number of key areas that are important to the value and the deal.
1. Normalized EBITDA and the Bridge to Adjusted EBITDA
Many deals start with EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) as the basis for valuation. A QoE report will usually calculate a normalized level of EBITDA and then explain the add-backs and adjustments needed to reconcile reported EBITDA to adjusted EBITDA.
Some examples of these adjustments might include:
- One-time items (a special legal expense, a nonrecurring project, a relocation)
- Out-of-period items
- Items that are not sustainable
- Items that need to be reclassified
Practical Example:
A QoE report for a manufacturing company revealed that a recent spike in profits was due to a one-time government grant and a discontinued product line. By removing these nonrecurring items, the normalized EBITDA was significantly lower than reported, leading the buyer to renegotiate the purchase price.
2. Revenue and Gross Margin Quality
A Quality of Earnings report may involve analyzing revenue and gross margins by customer, product, or segment, depending on the business model.
This can help address questions such as:
- Is revenue driven by a few customers?
- Are margins stable, improving, or challenged?
- Does the data support the revenue story of growth?
Once more, it's not about “finding problems.” It's about ensuring the revenue story is sound.
Practical Example:
A SaaS company’s QoE report identified that a large portion of revenue was from a single customer whose contract was not renewed. This insight allowed the buyer to adjust their valuation and request additional protections in the deal terms.
3. Operating Expense and Employee Analysis
This is where many buyers want more detail, especially around payroll, changes in headcount, use of contractors, and operating expenses.
What does a QoE report usually look for:
- Cost patterns that are consistent vs. unusual
- Costs that are “real” to run the business long-term
- Changes that impact future earnings power
If the company has experienced rapid growth or recently invested in hiring, this section of the report may be very useful in explaining what's going on and why.
4. Working Capital and the Working Capital “Target.”
Working capital is one of the areas that is most commonly subject to complications in deals that are negotiated too late in the process, usually because the subject hasn't been adequately addressed from the outset.
A Quality of Earnings Report usually includes an analysis of the working capital and helps to identify the normalized level of working capital that is required to run the business.
This is important because the buyer may want to ensure that they're not stepping into a business where they need to put in additional funds just to run the business.
When this subject is addressed adequately from the outset, it keeps the process clean and uncomplicated.
5. Monthly and Annual Trends
QoE reporting may also include a trend review to see how things change over time.
This is useful for businesses with:
- Seasonality
- Project-based revenue
- Changing sales cycles
- Pricing changes
- New customer wins or losses
This trend view helps the deal team distinguish normal business activity from changes that are significant to valuation.
Buy-Side vs. Sell-Side QoE
The QoE report can be useful on both sides of the table.
Buy-side QoE
For the buyer side, the QoE helps to "validate the earnings story, verify changes, and ultimately provide a sense of confidence with respect to valuation." Buyers use QoE reports to validate assumptions, negotiate price, and identify areas for further diligence or post-deal integration.
Sell-side QoE
For the seller side, the QoE "can assist with communicating the financial story, reducing uncertainty on the part of the buyer, and helping to organize diligence questions, which can result in a smoother process." Sellers use QoE reports to preemptively address concerns, streamline diligence, and support their valuation.
Stakeholder Roles
In addition to buyers and sellers, other stakeholders such as lenders, investors, and advisors may rely on the QoE report to assess deal risk, structure financing, or provide strategic guidance. Advisors play a key role in facilitating the process and ensuring findings are clearly communicated.
How Long Does a QoE Report Take?
Timelines vary based on complexity and speed of information availability, but most Quality of Earnings reports are finished in a matter of weeks.
If a transaction is in the offing, it is often helpful to get started earlier, as insights can shape negotiations and discussions around purchase price and working capital well before these issues become contentious.
How Reynolds + Rowella Helps
The QoE effort at Reynolds + Rowella is intended to offer early insight and a sound narrative with respect to earnings sustainability, trends, working capital, and key balance sheet metrics.
A standard QoE report might contain the following:
- EBITDA and add-backs to reconcile to adjusted EBITDA on a normalized basis
- Financial volatility on a monthly and annual basis
- Revenue and gross profit analysis by customer, product, or business segment
- Operating expense and headcount review
- Key balance sheet points
- Normalized working capital requirements to support the business
Post-Report Actions
After a QoE report is delivered, parties may renegotiate terms, request further diligence, or adjust the purchase price. The report often leads to follow-up questions and additional analysis, and its findings can be critical in finalizing deal structure and integration planning.
A QoE Report Is About Confidence, Not Criticism
A well-run deal is not one where no one asks any questions. It is one where the answers are clear.
The Quality of Earnings report is designed to help buyers and sellers agree on the actual economics of the business, so decisions are made with confidence, the negotiation is more informed, and the process is less prone to surprises.
Clarifying Your Earnings Ahead of a Transaction
If you're entering into a sale, acquisition, recapitalization, or financing, a Quality of Earnings analysis can help you answer the questions that always arise: what's repeatable, what needs an adjustment, and what a buyer or lender is going to focus on first.
Industry-Specific Considerations
The focus areas of a QoE report may differ by industry. For example, in manufacturing, inventory valuation and supply chain risks are critical, while in SaaS businesses, customer retention and deferred revenue are key. Industry-specific risks and typical adjustments should be considered to ensure the analysis is relevant and actionable.
Reynolds + Rowella can help you get your numbers in order and your story supported early on so that the process feels less bumpy and there are fewer surprises down the road. Reach out today to discuss your timeline, what you're trying to accomplish, and what type of QoE service would be most beneficial.
