Beginner's Guide to Quality of Earnings Reports in M&A

A quality of earnings (QoE) analysis helps buyers and investors look beneath the surface of standard financial statements to understand the true, sustainable profitability and financial health of a business. Below is a detailed, educational overview explaining what a quality of earnings analysis entails.

What Is a Quality of Earnings Analysis?

A quality of earnings analysis is a deep dive into a company's financial records that goes beyond the typical balance sheet or income statement. It aims to uncover hidden risks, inconsistencies, and to validate whether reported earnings are realistic and sustainable over time.

This kind of analysis is crucial during acquisitions or when major investments are considered because it offers confidence that the profits shown on paper are backed by real, repeatable business activity, rather than one-off events or accounting "tricks".

Why Is QoE Important?

Unlike a standard audit, which checks for compliance with accounting standards, the QoE focuses on recurring revenue, real cash flows, and the removal of nonrecurring events that might distort profitability.

High-quality earnings are:

• Stable and predictable over time
• Reliable and supported by actual cash flow
• Sustainable without one-time events or aggressive accounting

Low-quality earnings might result from:

• One-time sales that inflate income
• Unusual expense cuts that are unsustainable
• Aggressive accounting adjustments

This means buyers and investors can make better decisions about value, price, and future expectations.

Key Components of a Quality of Earnings Analysis

• Income Sustainability: Examines if net income is likely to continue in future periods or is affected by unusual, nonrecurring items.
• Cash Flow Validation: Compares bank statements and financial data to confirm profits are supported by cash that actually comes in the door.
• Accounting Practices: Assesses the consistency and transparency of accounting methods—looking for changes, errors, or overly optimistic projections.
• Working Capital Review: Evaluates whether the business can efficiently manage its operational cash needs, and highlights any red flags like negative net working capital or overstated receivables.
• Revenue Recognition: Checks that revenue is reported accurately and not manipulated by irregular sales or timing strategies.
• EBITDA Adjustments: Analyzes earnings before interest, taxes, depreciation, and amortization, stripping out nonrecurring or discretionary items to show "core" profitability.

How Does the Process Work?

A QoE analysis typically involves three main phases:

1. Data Gathering: Collecting historical financial data and bank records
2. Management Review: Interviewing management about inconsistencies and unusual items
3. Analysis & Reporting: Reconciling actual results with reported figures and creating detailed recommendations

Advisors use their expertise to benchmark company performance, standardize financials, and flag areas where earnings may be inflated or unsupported. The final report includes in-depth discussion of risks, detailed adjustments, and recommendations for buyers or sellers.

Common Issues Uncovered by QoE

• Revenue Issues: Unusual or one-time sales inflating income
• Cost Problems: Aggressive cost-cutting that is unsustainable
• Related Party Transactions: Significant dealings with related companies or individuals
• Timing Manipulation: Deferred revenue or expense manipulation
• Working Capital Issues: Problems with accounts receivable, obsolete inventory, or cash management

Who Needs a Quality of Earnings Analysis?

Any stakeholder involved in a business sale, acquisition, investment, or even internal management can benefit from QoE. For SMBs, it's an essential step to increase deal transparency, reduce surprises, and help both sides reach fair valuations based on reality rather than perception.