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A Quality of Earnings (QoE) review is a deep check of your profits to confirm they’re real, repeatable, and backed by cash. Think of it as stress-testing the story your numbers tell. Not just, “Did we make money?”, but “Would a new owner make the same money, without relying on quirks, one-offs, or messy accounting?”
Buyers, investors, and lenders use QoE during pre-deal work and formal due diligence. It shows up most often when a business is raising funding, refinancing, or preparing for a sale. For SMEs and owner-managed firms, it’s especially important because add-backs, related-party costs, and informal processes are common.
This guide explains what QoE is (in plain English), what buyers actually test, the red flags that cut price or slow a deal, and a practical pre-due diligence plan you can implement before you enter the spotlight.
Quality of Earnings explained in plain English (and how it differs from an audit)
Photo by Karolina Grabowska
A QoE review is a buyer-focused piece of work that asks a simple question: what level of earnings can this business sustain, and how much cash does it need to keep operating at that level? The output is often a normalised EBITDA number, plus findings on cash conversion and working capital.
An audit is different. Audits are designed to test whether the accounts are prepared in line with accounting standards and whether they’re free from material misstatement. A clean audit doesn’t mean your earnings are “buyer-ready”. It just means the numbers follow the rules, within materiality.
Management accounts are different again. They’re built for running the business, not for defending a purchase price. They can be useful, but buyers will still test them hard, because deal risk sits in the details.
QoE is not a valuation, but it drives valuation. If your sustainable earnings move down, price and terms move with it.
The core idea buyers care about: normalised EBITDA and repeatable profit
EBITDA is a rough measure of operating profit before interest, tax, depreciation, and amortisation. Buyers like it because it strips out funding choices and some non-cash items, so they can compare businesses more easily.
QoE then “normalises” EBITDA. That means adjusting for items that won’t continue under new ownership, such as a one-off legal case, a discontinued product line, or an owner’s personal costs run through the business.
Here’s the catch: buyers don’t accept add-backs because you say so. They test whether each adjustment is (1) real, (2) evidenced, and (3) likely to stay out after the deal. If an “exceptional” cost appears every year, it’s no longer exceptional. If savings depend on the founder working 70 hours a week, they may not be sustainable either.
What a QoE report usually covers beyond the profit and loss
QoE is broader than the P&L because buyers aren’t just buying last year’s profit. They’re buying future cash flows and taking on risks hiding in the balance sheet.
A typical QoE review looks at:
- Revenue quality: timing, contract terms, churn, concentration, and one-off sales.
- Expense quality: classification, missing accruals, owner and related-party items.
- Cash proof: whether profits show up as cash, and why they don’t.
- Working capital needs: stock, debtors, creditors, deferred revenue, seasonality.
- Balance sheet integrity: debt-like items, provisions, aged receivables, stale stock.
- Customer and supplier concentration: exposure to a few relationships.
Each area ties back to two deal questions: “What profit level is repeatable?” and “What cash is needed to support it?”
What buyers test in a QoE review, and what evidence they ask for
Buyers don’t just recalculate EBITDA. They validate how the business records transactions and whether the reported results match the underlying evidence. Expect them to triangulate the same story across the general ledger, bank activity, tax filings, contracts, and operational data.
For SMEs, the biggest time drain is usually not the analysis, it’s the scramble for support. If you prepare the schedules early, you control the pace and reduce last-minute rewrites that create doubt.
Revenue checks: is it earned, recorded in the right period, and likely to repeat?
Revenue testing is often where deals get tense. Buyers look for cut-off issues around month-end and year-end, early recognition on projects, milestone billing that doesn’t match delivery, and spikes that don’t repeat.
They also separate recurring revenue from one-offs. A strong month driven by a single large order may be fine, but it shouldn’t be priced like contracted, repeatable income. Buyers will also look at churn, renewals, pipeline coverage, and customer concentration.
Common requests include sales by customer (monthly), contract samples, invoice listings, a credit note log, deferred revenue schedules, and aged receivables with notes on slow payers.
Expense and margin tests: do costs match the revenue, and are add-backs real?
Expense testing is about completeness and classification. Buyers scan for costs pushed below EBITDA, routine spend capitalised as capex, and under-accrued liabilities (bonuses, commissions, contractor invoices, holiday pay, or VAT and payroll taxes).
Margins are a quick lie detector. If gross margin swings without a clear operational reason, buyers assume something is misposted, missing, or overly optimistic.
Add-backs get special scrutiny. If you claim “non-recurring” recruitment fees every year, or ongoing consultancy as a one-off, buyers will treat them as normal. Evidence matters: payroll reports, supplier spend by vendor, detailed general ledger exports, and an add-back pack with invoices and plain-English explanations.
Proof of Cash: do the profits convert into money in the bank?
If profit is the story, cash is the proof. Buyers reconcile trading results to bank movements to see whether reported earnings actually turned into cash, and to spot missing liabilities or related-party flows.
A business can be profitable and still cash-poor for valid reasons (growth, stock build, long debtor days). The problem is when the business can’t explain the gap, or when the gap is caused by weak credit control, unrecorded bills, or aggressive revenue recognition.
Expect requests for bank statements, bank reconciliations, aged payables, tax filings, loan statements, and a schedule of related-party transactions. If cash evidence is weak, deal teams often rework EBITDA and may assume a higher risk buffer.
Net working capital and balance sheet tests that affect cash at closing
Net working capital (NWC) is the day-to-day capital tied up in debtors, stock, and creditors. Buyers usually set an NWC target, then adjust the purchase price if you deliver more or less working capital at completion. It’s one of the most common sources of last-minute negotiation.
Seasonality matters. A year-end balance sheet might not reflect the normal position. Buyers prefer monthly trends so they can see what “normal” looks like.
Balance sheet testing also looks for stale stock, slow receivables, prepayments that won’t convert to value, missing accruals, deferred revenue obligations, hidden debt-like items, and off-balance sheet commitments such as leases and long-term contracts.
QoE red flags that reduce price, slow deals, or trigger tougher terms
Red flags aren’t just “bad accounting”. They’re signals that earnings may not repeat, or that cash and liabilities are unclear. When that happens, buyers protect themselves with price reductions, earn-outs, escrows, or tougher warranties. In many mid-market deals, valuations are anchored to EBITDA multiples, so a reduction in sustainable EBITDA can quickly flow through to headline price. Cuts can be material, sometimes in the 10 to 30 percent range, when issues are widespread and poorly evidenced.
| Red flag | What it signals | Common deal impact |
|---|---|---|
| End-of-period revenue spikes | Cut-off risk, sales pulled forward | EBITDA haircut, earn-out |
| Rising debtor days | Collection risk, overstated revenue | Working capital increase, price chip |
| “One-off” costs every year | Normal costs dressed up as add-backs | Add-backs rejected |
| Missing accruals | Liabilities understated | Debt-like adjustment, escrow |
| Heavy customer concentration | Revenue fragility | Lower multiple, holdback |
| Weak reconciliations | Numbers can’t be trusted | Slower deal, tougher terms |
Red flags in revenue: big spikes, weak contracts, and aggressive cut-off
Buyers worry when revenue looks timed rather than earned. Examples include end-of-quarter invoicing pushes, recognising revenue before delivery, or large unbilled work that relies on future sign-off.
Weak contract hygiene also hurts. If key customers can cancel easily, or pricing and scope are unclear, revenue becomes less defensible. High returns and credits, growing aged receivables, and a single customer driving a large share of sales all reduce revenue quality.
The usual outcome is a re-rating of repeatable revenue, which lowers normalised EBITDA and often leads to retention-based earn-outs.
Red flags in expenses: repeated “one-offs”, missing accruals, and unclear related-party costs
Expense red flags tend to sit in the gaps. Bonuses and commissions not accrued, supplier invoices “held” after year-end, and payroll taxes not properly accounted for will surface in QoE.
“Misc” accounts are another common problem. If material spend is parked without clear narratives, buyers assume risk. Personal spend through the business also creates noise and prompts deeper review.
Related-party charges can be fine, but they need contracts and market logic. Rent, management fees, or shared staff costs without clear terms often become negotiation points and can be treated as ongoing expenses or risk reserves.
Red flags in cash and working capital: profits look strong but cash is tight
A persistent profit-to-cash gap is one of the fastest ways to lose buyer confidence. If sales rise but cash doesn’t, buyers will ask whether debtors are collectible, whether stock is moving, and whether creditors are being stretched to make cash look better than it is.
Overstocking, slow collections, and reliance on short-term funding all point to higher ongoing cash needs. That can push up the working capital target or lead to more “debt-like” items at completion.
In practical terms, it means a lower effective price, even if the headline number stays the same.
Red flags in finance controls: numbers change often and nobody can explain why
Controls are a trust issue. Late month-end closes, frequent journal corrections, missing reconciliations, and weak audit trails suggest the business can’t produce stable financial information.
Buyers also notice key-person risk in finance. If one person holds all system access and no one reviews their work, it’s a problem even if fraud isn’t suspected. Inconsistent KPI reporting is another tell, because it suggests the team can’t explain performance drivers.
Weak controls don’t just increase risk, they increase time and cost. That’s how deals stall.
How to fix QoE issues before due diligence, a practical pre-DD action plan
Pre-DD work is about getting ahead of questions and reducing surprises. Done well, it protects valuation, speeds the process, and stops your team being dragged into endless data pulls during a live deal. It also makes you a stronger operator, whether you sell or not.
Consult EFC typically sees the best outcomes when founders treat QoE prep like a short project: clean the numbers, build the bridge, and assemble evidence in a way a buyer can follow.
Build a clean normalised EBITDA bridge with evidence for every adjustment
Start with reported profit, then bridge to normalised EBITDA in a simple schedule. Keep it tight and defensible. Each adjustment should meet three rules: it’s truly one-off, it’s not required to run the business, and it’s supported by documents.
For each add-back, keep a small evidence folder with the invoice or payroll detail, a short explanation (what it was and why it won’t repeat), and the ledger reference. If an adjustment is judgement-based, write down the logic and what would change your view.
A clean bridge doesn’t just help price, it reduces debate. Buyers argue less when the support is clear.
Tighten month-end close, reconciliations, and management reporting so numbers hold up
You don’t need a heavy process, you need a consistent one. Aim for a monthly close that locks, reconciles, and explains. Bank recs should be done monthly, with clear reconciling items. Review AR and AP ageing with notes on large or old balances. Post sensible accruals for known costs, and check deferred revenue where customer obligations exist.
Then produce a pack that stays consistent each month: P&L, balance sheet, cash movement summary, key KPIs, and a rolling 13-week cash forecast. Buyers relax when they see discipline, because it reduces the odds of late surprises.
Reduce concentration risk and improve contract hygiene before the buyer asks
If one customer drives a large share of revenue, start tackling it early. Build a plan to broaden the base and document progress. Even small steps help if they’re visible and measurable.
Contract hygiene is often the quickest win. Renew key customer agreements, clarify scope and pricing, document service levels, and make sure the contract terms match invoicing and delivery. Clean CRM data also matters, because it supports churn and retention analysis.
On suppliers, document key terms and identify alternatives for critical inputs. Buyers pay more for businesses that don’t hinge on a handful of informal relationships.
Prepare a due diligence-ready data room that answers buyer questions fast
Speed builds confidence. A tidy data room prevents repeated questions and stops version chaos. Include 24 to 36 months of monthly financials, general ledger exports, revenue by customer, the add-back schedule with support, bank statements and reconciliations, AR and AP ageing, working capital trend analysis, debt and lease schedules, tax filings, and key contracts.
Use clear file names, consistent dates, and a single owner for version control. If you change a number, log why and where it changed. The aim is simple: make it easy for a buyer to verify the story without guesswork.
Conclusion
A Quality of Earnings review is a test of trust: trust that profits repeat, and trust that cash and liabilities are understood. Buyers don’t expect perfection, but they do expect clarity, evidence, and a management team that can explain the numbers without panic.
The best time to fix QoE issues is before due diligence starts, when you still control the pace and the narrative. Treat QoE prep as part of building a better business, not just preparing to sell one.
If you want a practical pre-DD review, support building a normalised EBITDA bridge, or help assembling a diligence-ready pack, speak with Consult EFC and get the work done before the deal pressure arrives.
