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Quality of earnings

A quality of earnings review is an accountant's analysis of whether a business's reported earnings are accurate, sustainable and correctly adjusted. It is not an audit.

Also called QoE

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Loupe editorial
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Definition

A quality of earnings (QoE) review is an accountant's analysis of how reliable and repeatable a business's reported earnings are. It tests add-backs, checks revenue and costs against bank records and source documents, looks for one-off items and examines working capital. It is not an audit, and it is usually commissioned by the buyer, or sometimes by the seller before going to market.

Add-backs

Add-backs are costs added back to reported profit to show what a business would earn under a new owner. They raise SDE and adjusted EBITDA, so each one needs evidence.

Working capital

Working capital is the money tied up in running a business day to day, mainly stock and money owed by customers, less money owed to suppliers. A sale needs to agree how much of it comes with the business.

Worked example

A fictional buyer is acquiring Fernhill Home Care, a fictional US business listed on adjusted EBITDA of $1,500,000. The buyer's accountants find:

  • $100,000 of add-backs for "one-off recruitment" that recur every year
  • $50,000 of revenue recorded before the service was delivered
  • a salary deduction for the owner's role that is $30,000 below the market rate for a replacement manager

Adjusted EBITDA after the review is $1,320,000. At a fictional multiple of 5, that is $900,000 less than the listed figure implied.

Adjusted EBITDA

Adjusted EBITDA is EBITDA after normalising adjustments, showing what a business would earn with a paid manager in the owner's seat. Larger small-business deals are usually priced on it.

Why buyers care

A quality of earnings review is one of the most direct ways to test whether the earnings you are paying for are real and will continue. Lenders and investors often ask for one on larger deals. The cost has to be weighed against the size of the deal, and on smaller deals buyers often carry out a narrower version of the same checks themselves.

The quality of the records also affects value. Loupe's valuation tool treats owner-prepared accounts as a negative factor and accounts that have been reviewed, audited or tested by a quality of earnings review as a positive one, because the figures behind the multiple are more trustworthy.

Related terms

  • Add-backs

    Add-backs are costs added back to reported profit to show what a business would earn under a new owner. They raise SDE and adjusted EBITDA, so each one needs evidence.

  • Adjusted EBITDA

    Adjusted EBITDA is EBITDA after normalising adjustments, showing what a business would earn with a paid manager in the owner's seat. Larger small-business deals are usually priced on it.

  • Normalised earnings

    Normalised earnings are profits restated to show what a business would earn in a typical year under a new owner, after removing one-off items and correcting costs that are not at market rates.

  • Due diligence

    Due diligence is the investigation a buyer carries out before committing to a purchase, testing the finances, contracts, legal position and operations against what the seller has described.

  • Working capital peg

    A working capital peg is the agreed level of working capital a business must contain at completion. The price moves up or down by the difference between the actual figure and the peg.

Guides

  • Due diligence: what to check and in what order

    A sequence for due diligence that tests what could end the deal first, while it is still cheap to find out, and leaves the detailed and expensive work until the deal looks sound.

    10 minutes to read

  • Add-backs: which hold up and which do not

    Add-backs turn the profit in the accounts into the earnings on a listing, and each one is paid for several times over in the price. This guide shows how to test them and which usually survive.

    9 minutes to read

  • SDE and EBITDA explained with worked examples

    SDE and adjusted EBITDA both restate a business's profit for a buyer, but they answer different questions. This guide builds each one up line by line for two fictional businesses and shows which to use.

    9 minutes to read

Red flags

  • Large or undocumented add-backs

    Add-backs raise the earnings a price is based on. When they are large, vague or unsupported, much of the asking price rests on claims rather than records.

    Severity: price it inFinancials

  • Tax returns that do not match the accounts

    When the profit in the tax returns cannot be reconciled to the profit in the accounts, you cannot tell which figures to trust, and there may be tax owed.

    Severity: deal breakerFinancials

  • One-off revenue inside the last 12 months

    A contract, windfall or spike that will not repeat can sit inside the last 12 months and be priced as if it will. Take it out before you value the business.

    Severity: price it inFinancials

  • Reluctance to share records

    The seller delays, filters or refuses access to the financial and operating records you need to check the listing. Past a certain point, what you cannot see matters more than what you can.

    Severity: deal breakerSeller and process

Free tools

  • See a low, likely and high value from the figures you have, and whether the asking price holds up.

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