What Is a Quality of Earnings Report? A PE Buyer's Guide

If you are buying a mid-market company, the quality of earnings report is the single most important piece of financial diligence you will commission. It is the document that separates what the seller says the business earns from what it actually earns — on a normalized, repeatable, cash-adjusted basis.

Yet despite its importance, many first-time PE buyers and independent sponsors underestimate what a good QoE should cover, when to commission one, and how to read the results. This guide breaks it all down.

What Is a Quality of Earnings Report?

A quality of earnings (QoE) report is a financial analysis performed by an independent accounting or advisory firm that validates — or challenges — the earnings a target company has reported. It goes beyond the audit. While audited financial statements confirm that numbers comply with GAAP, a QoE digs into whether those numbers are sustainable, repeatable, and reflective of the business's true economic performance.

The core output is an adjusted EBITDA figure — the earnings number the buyer should actually underwrite. This adjusted number accounts for one-time items, owner-related expenses, accounting anomalies, and other factors that distort the reported financials.

Think of it this way: an audit tells you the financial statements are prepared correctly. A QoE tells you whether the business actually makes the money the seller claims it makes.

Who Orders a Quality of Earnings Report?

The buyer commissions the QoE. This is non-negotiable in institutional private equity and increasingly standard for independent sponsors and family offices acquiring companies above $5 million in enterprise value.

In some cases, sellers will commission a sell-side QoE before going to market. This can accelerate the process by surfacing and pre-addressing issues that would otherwise arise during buyer diligence. However, most buyers will still commission their own buy-side QoE because the analytical lens is different — a sell-side report is inherently prepared with the seller's interests in mind.

Who performs the QoE? Typically a mid-market accounting or transaction advisory firm. The Big Four do QoE work for larger deals, but for mid-market transactions (enterprise values of $10M-$500M), regional and national firms with dedicated transaction advisory practices often provide better value, deeper attention, and faster turnaround.

What Does a Quality of Earnings Report Include?

A comprehensive QoE covers significantly more than just adjusted EBITDA. Here is what a thorough report should analyze:

Adjusted EBITDA Bridge

This is the heart of the report. Starting from reported EBITDA, the QoE firm builds a bridge of adjustments:

• Non-recurring items. One-time legal settlements, restructuring costs, COVID-related expenses, natural disaster impacts, and other items that are not expected to recur. Each adjustment should be individually documented and supported.

• Owner-related adjustments. In founder-owned businesses, owner compensation, personal expenses run through the business, above-market rent paid to owner-related entities, and related-party transactions that would not exist post-acquisition.

• Pro forma adjustments. Normalizing for acquisitions made during the period, new contracts signed but not yet at run rate, and cost savings already implemented but not yet fully reflected in trailing financials.

• Accounting policy adjustments. Revenue recognition timing, inventory valuation methods, capitalization versus expensing decisions, and other policy choices that may differ from buyer expectations.

Revenue Quality Analysis

Revenue is not created equal. The QoE should break down revenue by:

• Recurring vs. non-recurring. What percentage of revenue comes from contractual, subscription, or recurring sources versus one-time projects or transactions?

• Customer concentration. If the top customer represents 25% or more of revenue, the buyer needs to understand the nature of that relationship, contract terms, and switching costs.

• Revenue trend analysis. Is growth coming from new customer acquisition, existing customer expansion, or price increases? Each has different sustainability characteristics.

• Backlog and pipeline. For project-based businesses, the QoE should assess the current backlog and pipeline to evaluate near-term revenue visibility.

Working Capital Analysis

Working capital is often where deals get repriced. The QoE should establish:

• Normalized working capital. What level of net working capital is required to operate the business at its current level? This becomes the working capital peg in the purchase agreement.

• Seasonality. If the business has seasonal fluctuations, the QoE must account for these to avoid setting the peg at an artificially high or low point.

• Trend analysis. Are days sales outstanding (DSO) or inventory days trending in the wrong direction? Deteriorating working capital metrics can signal underlying operational issues.

Debt and Debt-Like Items

The QoE should identify all obligations that function like debt but may not appear on the balance sheet:

• Deferred revenue and customer deposits
• Capital lease obligations
• Unfunded pension liabilities
• Pending litigation
• Deferred compensation arrangements
• Tax liabilities (especially in pass-through entities)

Capital Expenditure Analysis

Understanding the true maintenance capex requirement is critical for cash flow modeling:

• Maintenance vs. growth capex. What capital expenditure level is required just to maintain current operations versus what is discretionary or growth-oriented?

• Deferred capex. Has the seller been under-investing in capital assets to inflate near-term cash flow? This is a common issue in owner-operated businesses approaching a sale.

Red Flags in a Quality of Earnings Report

After facilitating hundreds of PE transactions, here are the red flags that should trigger deeper investigation — or walk-away conversations:

1. Large Adjustments Relative to Reported EBITDA

If adjustments exceed 30-40% of reported EBITDA, scrutinize every line item. Large adjustments are not automatically disqualifying, but each one should have clear documentation and a defensible rationale. Stacking multiple "one-time" items that recur annually is a classic warning sign.

2. Customer Concentration Above 20%

A single customer representing more than 20% of revenue creates significant risk. Understand the contract terms, relationship history, and what happens to that revenue post-acquisition — especially if the departing owner has personal relationships driving the business.

3. Revenue Growth Driven Entirely by Price Increases

If volume is flat or declining but revenue is growing through price increases, sustainability is questionable. How much pricing power remains? What is customer sensitivity to further increases?

4. Deteriorating Working Capital Trends

If DSO has increased by 15+ days or inventory turns have slowed materially over the trailing period, something is changing in the business. This often signals customer payment issues, obsolete inventory, or operational inefficiency.

5. Capex Significantly Below Depreciation

When capital expenditures consistently run below depreciation, the seller may be harvesting the business rather than maintaining it. The buyer inherits a capex catch-up obligation that reduces the true free cash flow of the business.

6. Related-Party Transactions

Any meaningful revenue from or expenses paid to entities controlled by the seller must be scrutinized. These transactions may not continue post-close, and the terms may not reflect market rates.

How to Read a Quality of Earnings Report

When you receive the QoE, here is the framework for evaluating it:

Step 1: Start with adjusted EBITDA. Compare it to the seller's presented EBITDA. If there is a significant gap, understand every adjustment driving the difference.

Step 2: Evaluate revenue quality. Look at the revenue mix, concentration, and growth drivers. Is the revenue base one you would underwrite at the same multiple?

Step 3: Assess working capital. Compare the QoE provider's recommended normalized working capital figure to what the seller proposed. This directly impacts the purchase price.

Step 4: Identify debt-like items. Every identified debt-like item reduces the effective enterprise value to the seller. Make sure these are captured in the purchase agreement.

Step 5: Stress-test the assumptions. For every pro forma adjustment the seller has proposed, ask: what happens if this does not materialize? Build a downside case using only the adjustments you have high confidence in.

When to Commission a Quality of Earnings Report

Timing matters. Commission the QoE as early as feasible in the diligence process — ideally once you have a signed LOI and access to the data room. The QoE typically takes 3-5 weeks for a mid-market transaction, and findings often inform other diligence workstreams and price negotiations.

Do not wait for perfect data. A good QoE provider can work with imperfect financial records — that is part of the value they deliver. Waiting for the seller to "clean up" their financials before starting the QoE wastes time and eliminates the benefit of independent analysis.

For sell-side QoE: If you are preparing a business for sale, commissioning a QoE 3-6 months before going to market allows you to identify and address issues that would otherwise surface during buyer diligence and potentially reduce the purchase price or kill the deal.

How BluWave Helps

Finding the right QoE provider is not as simple as calling your audit firm. The best QoE providers for mid-market PE transactions have specific experience with your deal size, industry, and transaction complexity.

BluWave's Business Builders' Network includes pre-vetted transaction advisory firms that specialize in PE-grade quality of earnings work. When a PE firm or independent sponsor needs a QoE provider, BluWave's team identifies the exact-fit firms based on industry expertise, deal size experience, geographic coverage, and availability — typically within one business day.

We also connect firms with the interim CFOs and financial talent needed to address QoE findings post-close. When the QoE reveals that the target company's finance function needs upgrading, having a seasoned interim CFO ready to step in at close can protect the investment thesis.

Need a QoE provider for your next deal? Connect with BluWave and our team will match you with pre-vetted transaction advisory firms that fit your specific requirements.

BluWave connects private equity firms and independent sponsors with pre-vetted service providers for transaction diligence, portfolio company operations, and value creation execution. Learn more at bluwave.net.