Why understanding the true sustainability of a business's cash flow is the difference between a winning investment and a costly mistake

In the high-stakes world of business acquisitions, reported profits can be seductive. A healthy-looking income statement might seem like a green light, but savvy acquirers know that the story of a business is rarely told by the surface-level numbers alone. What if those impressive earnings were inflated by a one-time sale, propped up by unsustainable accounting practices, or masking deep operational risks? This is where the discipline of a Quality of Earnings (QoE) analysis becomes one of the most critical tools in any buyer's arsenal.

Whether you are a first-time buyer navigating your initial purchase or a seasoned investor building a portfolio, understanding the true, sustainable cash flow of a target company is paramount. A QoE report cuts through the noise, providing a rigorous, independent analysis that goes far beyond a standard audit. It is not just about verifying the numbers; it is about understanding their quality, stability, and predictability. In an acquisition landscape where over 3.2 million businesses are for sale and monthly transactions exceed $6.5 million, the ability to distinguish between genuine earnings and accounting illusions can mean the difference between a successful investment and a costly mistake.

What is a Quality of Earnings (QoE) Report?

A Quality of Earnings report is a detailed, third-party analysis of a company's financial records, specifically designed to assist in a merger or acquisition (M&A) transaction. Its primary goal is to verify that a company's reported earnings are sustainable and to present a clearer picture of its future cash-generating capabilities. Conducted by specialized CPA firms or financial due diligence professionals, the QoE report serves as an independent, objective examination that both buyers and sellers can rely on during the transaction process.

It is crucial to distinguish a QoE analysis from a traditional financial audit. While an audit confirms that financial statements comply with Generally Accepted Accounting Principles (GAAP), a QoE analysis is purpose-built for a deal. It scrutinizes the financials through the lens of a potential buyer, asking the tough questions that an audit might not address. Does the business generate consistent cash flow? Are the margins sustainable? What adjustments need to be made to reflect the true operational performance? These are the questions that drive a QoE analysis.

Key Insight: A business can have perfectly compliant financial statements that still obscure the reality of its operations. A company might recognize revenue aggressively, capitalize expenses that should be expensed, or carry outdated inventory at inflated values—all while remaining technically GAAP-compliant. A QoE analysis strips away these layers to reveal the underlying economic truth.

A QoE analysis examines the amount of working capital required to operate the business without the buyer having to infuse additional capital after the closing.

The Buyer's Shield and the Seller's Edge

Once considered a tool used exclusively by buyers during due diligence, the QoE report is increasingly being commissioned by sellers before they even go to market. This shift highlights its dual role in modern M&A, serving as both a defensive shield for the buyer and a strategic advantage for the seller. Sell-side QoE reports are becoming standard practice for all but the smallest transactions, particularly when dealing with sophisticated buyers such as private equity firms or strategic acquirers.

Critical Takeaway: Sellers who invest in a sell-side QoE before going to market position themselves as credible, prepared partners. They can confidently defend their asking price, address buyer concerns proactively, and negotiate from a position of strength. In contrast, sellers who skip this step often find themselves on the defensive during due diligence, scrambling to explain discrepancies and watching their leverage evaporate.

Key Areas of Scrutiny in a QoE Analysis

A comprehensive QoE report dissects a company's financials from multiple angles. While the scope can vary depending on the business complexity and the concerns of the buyer, several core components are almost always examined. Understanding these areas will help both buyers and sellers prepare for the rigor of the process.

1. Adjustments to EBITDA: The Heart of the Analysis

This is the centerpiece of any QoE report. The analysis normalizes earnings by removing non-recurring, non-core, or personal expenses that a new owner would not incur. The goal is to arrive at a "normalized" or "adjusted" EBITDA that reflects the true, ongoing earning power of the business—the cash flow a buyer can reasonably expect to receive after taking ownership.

Common adjustments include the owner's excess salary (compensation above market rate for the role), one-time legal fees, costs associated with discontinued product lines, or expenses related to personal assets run through the business (such as a vehicle or country club membership). The QoE analysis will also normalize for timing issues, such as bonuses paid early or late for tax purposes, or revenue that was accelerated or deferred.

Real-World Example: Consider a manufacturing business reporting $1.2 million in EBITDA. During the QoE analysis, the following adjustments might be identified:

•The owner's salary is $300,000, but a market-rate replacement would cost $150,000 (adjustment: +$150,000)

•The company incurred $50,000 in legal fees related to a one-time patent dispute (adjustment: +$50,000)

•The business wrote off $30,000 in bad debt that should have been reserved over multiple years (adjustment: -$10,000)

After these adjustments, the normalized EBITDA becomes $1.39 million—a 16 percent increase that significantly impacts valuation.

Important Note: Not all adjustments favor the seller. A thorough QoE will also identify negative adjustments, such as underreported expenses, deferred maintenance that will require immediate capital investment, or revenue that was recognized prematurely. The independence of the QoE provider is critical here; their job is to present an accurate picture, not to advocate for either party.

2. Net Working Capital (NWC) Analysis

Net working capital represents the difference between a company's current assets (such as accounts receivable and inventory) and current liabilities (such as accounts payable and accrued expenses). The QoE report determines the appropriate level of working capital a buyer will need to inherit to run the business smoothly from day one without injecting extra cash.

This analysis is crucial for negotiating the NWC peg in the purchase agreement. Most M&A transactions are structured on a "cash-free, debt-free" basis, meaning the seller keeps the cash but pays off the debt, and the purchase price is adjusted based on the actual NWC at closing compared to the target NWC. If the business is delivered with insufficient working capital, the purchase price is reduced dollar-for-dollar; if it is delivered with excess working capital, the price is increased.

Why This Matters: Post-closing working capital disputes are among the most common sources of friction in M&A transactions. A well-prepared QoE establishes a defensible NWC target based on historical averages, seasonal fluctuations, and operational needs—preventing costly arbitration or litigation.

3. Revenue Recognition and Quality

Are revenues being booked appropriately, or is the company using aggressive accounting policies that inflate the top line? The QoE analysis will test for premature revenue recognition, such as booking sales before goods are shipped or services are rendered. It will also identify customer concentration risks—if 40 percent of revenue comes from a single customer, what happens if that relationship ends?

The analysis will break down revenue by product line, service offering, or customer segment, and examine margin trends over time. Are margins improving, stable, or declining? If margins are declining, is this due to competitive pressure, rising input costs, or operational inefficiencies? Understanding the drivers of revenue quality is essential for forecasting future performance.

Additionally, the QoE will assess the sustainability of the revenue base. Is the business dependent on a few large contracts that are up for renewal? Are there seasonal fluctuations that need to be understood? Is the revenue recurring and predictable, or is it project-based and lumpy? These insights help buyers model future cash flows with greater accuracy.

4. Proof of Cash and Revenue

To ensure the numbers are real and not the product of accounting manipulation, the QoE process includes a "proof of revenue" and "proof of cash." This involves tying the revenues and cash balances reported on the financial statements directly back to the company's bank statements.

This step is particularly important in smaller businesses where financial controls may be less robust. The proof of cash reconciles the beginning and ending cash balances, accounting for all deposits and withdrawals, and identifies any discrepancies. The proof of revenue verifies that the sales reported on the income statement actually resulted in cash deposits, providing assurance that revenue is not being overstated.

Red Flag Alert: In some cases, this analysis uncovers significant issues, such as revenue being recorded for sales that were never collected, or cash receipts that were not properly recorded as revenue. These findings can have a material impact on the valuation and the buyer's willingness to proceed.

5. Operational Red Flags and Risk Factors

The QoE analysis extends beyond the financials to identify operational risks that could impact future performance. This can include evaluating the age of equipment and the potential for large capital expenditures, assessing employee turnover rates and the risk of losing key personnel, or identifying dependency on a few key suppliers.

Other operational red flags might include pending litigation, regulatory compliance issues, or changes in the competitive landscape. The QoE provider will interview management to understand these risks and assess their potential impact on earnings. For example, if a key piece of manufacturing equipment is 20 years old and nearing the end of its useful life, the buyer needs to budget for its replacement—a cost that could run into the hundreds of thousands of dollars.

Buyer Beware: Understanding these operational dynamics is essential for buyers who want to avoid unpleasant surprises after closing. It also helps sellers address these issues proactively, either by making necessary investments before going to market or by adjusting their asking price to reflect the buyer's future costs.

The Process: What to Expect

A typical QoE analysis unfolds over 30 to 45 days and is conducted by a specialized CPA firm or financial due diligence firm. The timeline depends on the complexity of the business, the quality of the financial records, and how quickly the management team can respond to information requests.

The process generally follows these steps:

Step 1: Information Gathering. The QoE provider will request a comprehensive set of documents, including historical financial statements (typically three to five years), interim financial statements, tax returns, bank statements, customer and vendor contracts, and any financial projections. They will also conduct interviews with the management team to understand the business model, key drivers of performance, and any unusual transactions.

Step 2: Preliminary Analysis and Discussion. The provider will perform an initial review of the financials and identify areas that require deeper investigation. They will discuss their preliminary findings with management to clarify any questions and gather additional context.

Step 3: Adjustments to the Financial Statements. Non-recurring revenue and expenses are removed, and the financials are normalized to reflect only the core business activities. This is where the adjusted EBITDA calculation takes shape.

Step 4: Detailed Analysis. The strengths and weaknesses of the business are examined in detail. This includes analyzing trends in revenue and margins, assessing the quality of assets, evaluating working capital needs, and identifying operational risks. The provider will also test the sustainability of earnings and the reliability of financial projections.

Step 5: Finished Product. The final QoE report is delivered, typically as a detailed PDF or spreadsheet. While there is no standard format, the report will methodically walk through the findings, adjustments, and observations. It will include a reconciliation from reported EBITDA to adjusted EBITDA, an analysis of net working capital, and commentary on key risks and opportunities.

For Buyers: The QoE is an indispensable part of due diligence, providing the confidence needed to proceed with a major investment.

For Sellers: A proactive, sell-side QoE is a powerful statement. It signals that you are a serious, prepared, and transparent partner, ready to defend your valuation and facilitate a smooth, successful transaction.

The Cost of a QoE: An Investment, Not an Expense

The cost of a QoE analysis varies widely based on the size and complexity of the business. For a small company, a basic QoE might cost as little as $5,000, while a comprehensive report for a mid-sized firm can exceed $100,000. Private equity firms and sophisticated buyers typically expect to see well-known regional or national firms prepare these reports for companies with revenue above $10 million to $25 million.

Several factors influence the cost, including:

•The size of the business

•How closely the financials adhere to GAAP

•The cleanliness of the financial statements

•The complexity of the business model

•The number of entities involved

•The industry in which the business operates

A company with multiple subsidiaries, complex revenue recognition policies, or significant related-party transactions will require a more extensive (and expensive) analysis.

ROI Perspective: While the cost may seem steep, it is important to view the QoE as an investment rather than an expense. For buyers, the QoE can prevent a catastrophic overpayment or uncover risks that would have destroyed value post-closing. For sellers, the QoE can justify a higher purchase price, accelerate the deal timeline, and increase the likelihood of a successful close. In both cases, the return on investment is substantial.

When to Commission a QoE: Timing Matters

For buyers, the QoE is typically commissioned after the Letter of Intent (LOI) is signed and the parties have entered into an exclusivity period. This is the start of the formal due diligence phase, and the QoE is a central component of the financial due diligence process. The findings from the QoE will inform the final purchase agreement, including the purchase price, working capital peg, and any representations and warranties.

For sellers, the optimal time to commission a sell-side QoE is before going to market. This allows you to identify and address issues in a low-pressure environment, uncover additional EBITDA adjustments, and position your business as a credible, transparent opportunity. Sellers who wait until they are in due diligence to discover problems often find themselves negotiating from a position of weakness, with limited options and a buyer who is questioning their credibility.

Strategic Timing: In some cases, sellers may choose to commission a QoE after receiving initial interest from buyers but before signing an LOI. This can be a strategic move if you anticipate that buyers will have concerns about your financials or if you want to differentiate your business in a competitive process.

Red Flags That a QoE Will Uncover

A rigorous QoE analysis is designed to identify issues that could impact the value or viability of a transaction. While every business is different, certain red flags appear frequently in QoE reports. Being aware of these common issues can help both buyers and sellers prepare for the process.

Customer Concentration: If a significant portion of revenue comes from a small number of customers, the business is vulnerable to losing a major account. Buyers will want to understand the strength of these relationships and the likelihood of retention post-closing.

Declining Margins: If gross or operating margins are trending downward, this could signal competitive pressure, rising costs, or operational inefficiencies. The QoE will investigate the root causes and assess whether the trend is likely to continue.

Aggressive Revenue Recognition: If the company is booking revenue before it is earned or collectible, this inflates earnings and creates a false picture of performance. The QoE will test for compliance with revenue recognition standards and adjust earnings accordingly.

Inadequate Financial Controls: Weak internal controls increase the risk of errors, fraud, or misstatements in the financial records. Buyers will be concerned about the reliability of the financials and may require additional safeguards in the purchase agreement.

Related-Party Transactions: If the business transacts with entities owned by the seller or family members, buyers will want to ensure these transactions were conducted at arm's length and will continue post-closing. Related-party transactions can also create tax and legal complications.

Deferred Maintenance or Capital Expenditure Needs: If the business has deferred necessary maintenance or capital investments, the buyer will need to budget for these costs post-closing. The QoE will identify these needs and estimate their financial impact.

Pending Litigation or Regulatory Issues: Any legal or regulatory exposure can have a material impact on the business's value and risk profile. The QoE will identify these issues and assess their potential impact on future earnings.

The Bottom Line: Clarity, Confidence, and Successful Deals

In the complex world of business acquisitions, information asymmetry is the enemy of successful deals. Sellers know more about their businesses than buyers do, and this imbalance creates risk, mistrust, and opportunities for deals to fall apart. A Quality of Earnings analysis levels the playing field by providing an independent, objective assessment of a company's financial performance and operational health.

For buyers, the QoE is a critical risk management tool that validates earnings, uncovers hidden issues, and provides the confidence needed to move forward with a major investment. It is not just about confirming the numbers; it is about understanding the story behind the numbers and making an informed decision based on facts rather than assumptions.

For sellers, the QoE is a strategic asset that demonstrates credibility, supports a higher valuation, and accelerates the deal process. By investing in a sell-side QoE before going to market, sellers can control the narrative, address issues proactively, and position their businesses as attractive, transparent opportunities for sophisticated buyers.

Final Thought: In an acquisition landscape where over 3.2 million businesses are for sale and competition for quality deals is fierce, standing out requires more than just a good story—it requires credible, verified data.

Whether you are a first-time buyer taking your first step into entrepreneurship through acquisition, a serial acquirer building a portfolio, or a broker advising clients on both sides of the table, understanding the power and purpose of a Quality of Earnings analysis is essential to navigating the M&A process with clarity, confidence, and a much higher probability of achieving a successful outcome.

The next time you evaluate a business for acquisition—or prepare your own business for sale—ask yourself: Do I truly understand the quality, sustainability, and predictability of these earnings? If the answer is anything less than a confident yes, it may be time to commission a Quality of Earnings analysis. The investment you make today could save you from a costly mistake tomorrow, or unlock hidden value that transforms a good deal into a great one.

References

[1] Clearly Acquired. "Small Business Acquisition Trends 2025." Accessed Dec 19, 2025.

[2] Morgan & Westfield. "Quality of Earnings in M&A – The Ultimate Guide." Accessed Dec 19, 2025.

Property of Acquire Weekly. For educational purposes only.