If you’re buying a business, the seller will hand you financial statements that tell a story. A Quality of Earnings (QofE) analysis exists to answer a harder question: is that story true, and will it still be true after you own the company?
A QofE isn’t about catching a seller in a lie. Most owners aren’t hiding anything — but the way a private business keeps its books is rarely the way a buyer needs to see them. Owner perks run through the P&L, one-time events distort a good year, revenue gets recognized inconsistently, and the “profit” on paper may never have shown up as cash. A QofE rebuilds the numbers to reveal what the business actually earns on a sustainable, run-rate basis.
The heart of it: Adjusted EBITDA
The centerpiece of every QofE is a normalized, or “adjusted,” EBITDA figure. We start with reported earnings and methodically add back or remove items that won’t carry forward to the new owner:
- One-time and non-recurring items — a lawsuit settlement, a PPP loan, a flood, a single unusually large project.
- Owner and related-party adjustments — above-market salaries, personal expenses, family on payroll, or rent paid to an entity the owner controls.
- Pro-forma adjustments — the full-year effect of a price increase, a new contract, or a cost already eliminated.
Each adjustment is documented and defensible. The result is a clean number you can actually build a valuation on — and defend in a negotiation.
Beyond earnings: the rest of the report
Adjusted EBITDA is the headline, but a complete QofE digs into several other areas that frequently change how a buyer thinks about price and risk:
- Quality of revenue. How much is recurring versus one-time? How concentrated is the customer base? If one client is 40% of sales, that’s a different business than the income statement suggests.
- Proof of cash. We tie reported revenue and expenses back to the actual cash that moved through the bank — the single most reliable test of whether the financials reflect reality.
- Net working capital. We analyze the trend to help set a fair target (the “peg”) so you don’t overpay at close or get squeezed afterward.
- Debt and debt-like items. Accrued liabilities, deferred revenue, unpaid taxes, and other obligations that should reduce the price you pay.
A QofE doesn’t just confirm the number. It tells you which numbers to trust, which to question, and where the risk really lives.
How it differs from an audit
This trips up a lot of first-time buyers. An audit looks backward and asks whether last year’s statements were fairly presented under accounting standards. A QofE looks forward and asks whether the earnings are sustainable for you, the new owner. An audit samples and tests; a QofE analyzes at the account and transaction level. An audit produces a formal opinion; a QofE produces actionable findings you take to the table. A clean audit is no substitute for a QofE — and most lower-middle-market targets have never been audited at all.
When you need one
As a rule of thumb, a QofE is considered best practice for any acquisition above roughly $1M in value, and it’s effectively mandatory once institutional lenders or LPs are involved. The cost is modest against the size of the decision — and against the cost of buying a problem you didn’t see coming.
That’s the whole point of diligence: not to kill deals, but to let you do the right one with your eyes open.