What Is a Quality of Earnings Report?

A quality of earnings report is an analysis of a business's profit, built for a sale or purchase. Often called a QoE, it adjusts reported results to remove one-off and unusual items, so a buyer can see what earnings are likely to repeat. It is not an audit, and it is not a valuation.

By Jake McKenna, FounderPublished Last reviewed

This is general information, not tax or investment advice.

What is a quality of earnings report?

One advisory firm describes a QoE as a specialized financial analysis designed for transaction purposes. It normalizes results by stripping out one-time or unusual items, to show the earnings the business can sustain. It is not a test of whether the statements follow accounting rules.

In plain terms: reported profit is the number in your books. Quality of earnings asks how much of that number will still be there next year, under a new owner.

Quality of earnings vs business valuation: what is the difference?

They answer different questions.

Item Quality of earnings Valuation
Question How much of the profit is real and repeatable? What is the business worth?
Output Adjusted earnings and supporting analysis An opinion of value
Used for Checking the numbers behind a price Setting or testing a price

The two connect. According to the same advisory firm, the main focus of a QoE is adjusted EBITDA (earnings before interest, taxes, depreciation and amortization), which it says underpins most middle-market valuations. So a QoE feeds a valuation; it does not replace one.

This page explains the concept so you know what to expect if a buyer asks for one. English Oak does not prepare tax returns, audit or give investment advice.

Quality of earnings vs audit

According to the same source, an audit checks whether financial statements are fairly presented under accounting standards (GAAP), tests balances and transactions, and centers on net income over fiscal years. A QoE centers on adjusted EBITDA, looks at monthly data and also covers working capital and deal risks.

Item Audit Quality of earnings
Purpose Fair presentation under GAAP Sustainable earnings for a deal
Focus Net income Adjusted EBITDA
Period Fiscal years Monthly data, typically three years plus the trailing twelve months (per BPM)

Having audited statements does not remove the need for a QoE, according to that source. Buyers often still commission one.

What does a QoE look at?

The advisory firm lists these areas:

  • One-off and non-recurring items taken out of earnings.
  • Owner pay and discretionary spending. An owner who pays themselves far above or below a market wage distorts profit.
  • How much revenue depends on a few key customers.
  • Working capital needs.
  • Monthly trends, including seasonality and growth.

These depend on books that are accurate and consistent by month. That is the part a small business can control. See month-end close and our profit vs cash flow guide.

What does an adjustment look like?

Here is an illustrative case. The numbers are invented.

Example: a shop reports 200,000 of profit. Inside it sit a 30,000 one-time legal settlement (a cost that will not repeat) and an owner paid 40,000 below a market wage for the role. A buyer would add back the settlement and deduct the wage gap, giving adjusted profit of 190,000. The reported figure and the adjusted figure differ because one is a record and the other is an estimate of the future.

The point is the direction of each adjustment, not the amounts: costs that will not repeat go up the profit line, and costs a new owner would have to pay come down it.

Who asks for a QoE, and when?

Mainly buyers, during financial due diligence, says the same source. Sellers can also commission a sell-side QoE before going to market, which the same source says reduces the risk of price reductions later.

For lending, see how to prepare financials for a loan.

How can you get ready before anyone asks?

Preparation looks like ordinary good finance:

  1. Keep monthly books current and reconciled. Bookkeeping does this; catch-up bookkeeping fixes a backlog.
  2. Keep personal expenses out of the business accounts.
  3. Document unusual items as they happen, with a short note.
  4. Produce monthly management reports, so trends are visible.
  5. Read how to prepare financials for a loan for the related lender view.

Our fractional CFO service covers exit or acquisition preparation, including M&A and exit advisory. It starts from $2,500 a month on a custom, fixed monthly fee; see pricing and what we do.

When is a QoE not for you?

If you are not selling or buying a business, a QoE is probably not what you need. Clean monthly management reporting is a sensible first step.

If you only want to know whether the business is healthy, a fractional controller reviewing the monthly numbers may be enough, and it is a different job from a transaction review. Ask any firm quoting a QoE exactly what period it covers and who receives the report.

Need this done for you? See our Fractional CFO & Advisory service, or pricing. English Oak Financial does not prepare tax returns, perform audits or give investment advice. This guide is general information, not tax, legal or investment advice.

Sources

Common questions

What is quality of earnings in simple terms?

It is a check on how much of a business's reported profit is likely to repeat. It strips out one-time items to show earnings that are likely to repeat, usually for a buyer.

Is a quality of earnings report the same as an audit?

No. An audit tests whether statements are fairly presented under GAAP. A QoE focuses on adjusted EBITDA and sustainable earnings for a transaction.

Is a quality of earnings report a valuation?

No. A QoE tests earnings. A valuation puts a value on the business. The adjusted earnings from a QoE often feed the valuation.

Does English Oak prepare tax returns or audit?

No. English Oak does not prepare tax returns, audit or give investment advice. It helps keep the books and monthly reporting in order.

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