What is a Quality of Earnings (QoE) Report and Why Does It Matter?

Quality of Earnings: A Critical Part of Financial Due Diligence

When evaluating a business for acquisition, investment, or strategic decision-making, understanding the true financial health of a company is crucial. While traditional financial statements provide a snapshot of revenues, expenses, and profits, they often don’t tell the full story.

This is where a Quality of Earnings (QoE) report comes in—a powerful tool that goes beyond basic financial metrics to analyze the sustainability, accuracy, and reliability of a company’s earnings.

A QoE report helps investors, business buyers, and stakeholders separate actual operational earnings from misleading or non-recurring financial factors. By scrutinizing revenue streams, cost structures, and cash flow patterns, this report provides a transparent and realistic assessment of a business’s profitability and financial stability.

Key Components of a Quality of Earnings Report:

A well-prepared QoE report examines several critical aspects of a business’s financials. Below are the primary components analyzed in a quality of earnings review:

1. Revenue Analysis: Understanding the Stability of Income

One of the core elements of a QoE report is an in-depth revenue analysis. Not all revenue is created equal, and businesses sometimes include one-time gains, non-operating income, or unusual transactions that can distort profitability. The report looks at: Revenue consistency and growth trends over multiple periods. Customer concentration risks—does the company rely too much on a small number of customers? Recurring vs. non-recurring income—one-time sales or grants don’t contribute to long-term earnings sustainability. Revenue recognition policies—ensuring that revenue is reported in compliance with standard accounting practices. Understanding these factors helps investors determine whether the company’s income is stable, repeatable, and defensible in the future.

2. Expense Examination: Identifying Cost Irregularities

The report also scrutinizes expenses to assess whether the company’s cost structure is sustainable.

This includes: Normalizing one-time expenses, such as legal fees, restructuring costs, or large executive bonuses.
Identifying non-operational costs, like excessive owner salaries or personal expenses run through the business.
Assessing cost efficiency to determine if expenses are in line with industry benchmarks. 
By normalizing these expenses, the QoE report ensures that profitability is not overstated or misrepresented.

3. Earnings Normalization: Adjusting for Anomalies

Many businesses report earnings that include one-off gains, accounting adjustments, or extraordinary expenses. QoE reports adjust for these anomalies to provide an accurate view of the company’s true profitability.  Some common adjustments include: Non-recurring litigation settlements, Changes in accounting methods, Government grants or subsidies, and Unusual tax credits or deductions.

This normalization process helps potential buyers accurately assess how much profit the business will generate in the future under normal operating conditions.

4. Working Capital Assessment: Evaluating Liquidity and Financial Flexibility

A company's working capital—its current assets minus current liabilities—is a key indicator of short-term financial health. The QoE report analyzes: 

Inventory management—is inventory turning over efficiently, or is capital tied up in excess stock?
Accounts receivable and payable—are customers paying on time? Is the business paying vendors promptly?
Seasonality impacts—does the company have cash flow fluctuations due to seasonal sales cycles?
This section is crucial because a business with poor working capital management may struggle with liquidity even if its income statement appears strong.

5. Cash Flow Analysis: Understanding True Earnings Power

Cash flow is often a better indicator of financial strength than reported net income. A QoE report helps uncover how much cash a business actually generates after adjusting for working capital changes, capital expenditures, and debt obligations. This analysis includes:

Free cash flow—the real cash available after necessary expenditures.
Debt servicing capacity—can the business comfortably handle its current debt?
Recurring vs. non-recurring cash flow events—ensuring that reported profits translate into actual cash generation.

Why is a Quality of Earnings Report Important?

A Quality of Earnings report is essential for M&A transactions, private equity deals, and investment evaluations. Here’s why it matters:

1. Better Investment Decisions

Buyers and investors need to ensure that the company they are acquiring is financially sound. A QoE report allows them to: Verify reported earnings and identify any misrepresented financials. Understand profitability drivers and assess whether future earnings are sustainable, and avoid overpaying for a business by eliminating misleading financial factors.

2. Risk Mitigation: Spotting Red Flags Before It’s Too Late

Many acquisitions fail because buyers underestimate financial risks. A QoE report can uncover hidden liabilities, irregular accounting practices, or revenue dependencies that pose a threat. Examples include:

Overstated revenue due to aggressive accounting practices.
A sudden increase in profits due to one-time events.
Business dependence on a few key customers or suppliers.
Inconsistent or improper expense allocations.
By identifying these risks upfront, buyers can negotiate better deal terms or walk away from bad investments.

3. Enhanced Negotiation Leverage

With a well-prepared QoE report, buyers and investors can negotiate from a position of strength. If the report uncovers inconsistencies, it provides justification for: 

Renegotiating the purchase price to reflect the true earnings power.
Structuring the deal differently, such as including earn-outs or performance-based contingencies.
Requesting seller concessions, such as adjusting the working capital target.

4. Increased Transparency and Credibility

For business owners looking to sell, providing a QoE report upfront builds credibility with buyers and reduces transaction uncertainty. It shows that the seller is transparent about financial performance and ensures smoother negotiations.

Final Thoughts: The Power of a QoE Report

A Quality of Earnings report is one of the most critical financial due diligence tools in M&A and investment transactions. It helps buyers, investors, and lenders understand a company’s true earnings power, identify risks, and make informed decisions.

If you are considering buying a business, investing in a company, or preparing for a sale, conducting a QoE analysis is a prudent and strategic step to ensure transparency and value.

Need a Quality of Earnings Analysis? 

At O’Connell Advisory Group, we specialize in comprehensive financial due diligence to help buyers and investors make confident decisions. Our team provides clear, actionable insights so you can navigate acquisitions with certainty.

Contact us today to learn how we can support your next deal.