When buying or selling a business, understanding the company’s true financial health is critical. This is where quality of earnings (QoE) comes in. A QoE analysis serves to evaluate and verify a company’s earnings and identify potential financial or operational risks. Buyers and sellers can rely on this resource to gain a clearer understanding of the sustainability of a business’s earnings before a transaction. In this article, we dive into the quality of earnings checklist that analysts use to assess a business. Understanding these areas can help buyers and sellers make informed decisions, identify risks early, and navigate negotiations more effectively.
As an experienced quality of earnings specialist, Peak Business Valuation frequently provides QoE reports for businesses throughout the United States. If you are preparing to buy, sell, or merge a business, consider obtaining a quality of earnings report. Schedule a free consultation with Peak today to learn more!
What is a Quality of Earnings Checklist?
A quality of earnings checklist outlines the key financial areas that analysts review to evaluate a company’s earnings and identify potential risks before a transaction. The QoE report differs from a business valuation and financial audit. For example, a business valuation estimates a company’s fair market value. Financial audits focus on accounting accuracy and compliance. In contrast, a QoE analysis examines whether earnings are sustainable and reflective of normal business operations. Buyers, sellers, investors, and lenders often use this analysis during mergers, acquisitions, or financing transactions.
Most quality of earnings analyses follow a structured review process. This often includes reviewing financial statements, evaluating expenses and normalizing EBITDA, and identifying financial risks. QoE experts help interpret these findings and identify trends or inconsistencies that may impact negotiations or transaction decisions.
In the following sections, we discuss each step of the quality of earnings checklist. If you are looking to get started on this process for your business, schedule a free consultation with Peak Business Valuation. Feel free to also check out What is a Quality of Earnings Analysis? for further insight.
1. Review Financial Statements
When beginning the quality of earnings checklist, analysts start by reviewing the subject company’s financial documents. These often include tax returns, balance sheets, cash flow statements, and any other relevant documents from the past 3-5 years. As they review these statements, QoE experts analyze both the business’s financial trends and irregularities, as well as how they compare to industry standards. This analysis helps experts gain a quick understanding of the business’s financial position so they can be prepared for upcoming steps.
If you are preparing your business for a quality of earnings analysis, start by gathering and organizing these documents for a smoother experience. For more insights, feel free to check out Documents Needed for a Business Valuation.
2. Analyze Revenue Quality
After reviewing a business’s financial statements, the next step on the quality of earnings checklist is to analyze revenue quality. In this step, QoE analysts look for recurring revenue, customer concentration, trends, and unusual spikes in earnings. Examining these areas helps QoE professionals determine whether revenue is sustainable after a transaction. They provide their findings in a quality of earnings report, where they break down revenue and gross margin across product, customer, or distribution segments. This insight helps buyers and sellers know which parts of the business are thriving and which might require attention.
3. Evaluate Expenses and Normalize EBITDA
The third item on the quality of earnings checklist is to evaluate the business’s expenses and normalize EBITDA. In this step, quality of earnings experts review business expenses to identify unusual or non-recurring costs. Common valuation adjustments include owner-related expenses, one-time legal fees, or temporary increases in operating costs. Analysts then adjust earnings before interest, taxes, depreciation, and amortization to reflect the company’s normal operating performance. This process creates normalized EBITDA, which provides buyers and sellers with a clearer picture of sustainable cash flow to support effective due diligence.
4. Assess Working Capital
Next, QoE experts assess a business’s working capital to better understand the sustainability of the business’s reported earnings. To do this, analysts review trends in current assets and liabilities, such as accounts receivable, inventory, and accounts payable. They often examine monthly balances over multiple years to identify seasonal fluctuations or one-time events that may distort working capital levels.
After removing abnormal or non-recurring items, QoE professionals calculate a “normalized” working capital target. This target represents the typical level of working capital required to maintain ongoing operations. Buyers often use this figure during negotiations to ensure the business is transferred with sufficient liquidity to operate smoothly after closing.
If you are preparing to buy, sell, or finance a business, obtaining a quality of earnings analysis may be the right next step. Schedule a free consultation with Peak Business Valuation today to learn more!
5. Identify Financial Risks
Fifth, QoE experts conduct a thorough analysis of the business to identify potential financial or operational risks. These vulnerabilities might include high employee turnover, over-dependence on key suppliers or clients, pricing strategies, operational inefficiencies, or heavy owner dependence. With this insight, buyers can make informed decisions during due diligence, ensuring they fully understand the business they are acquiring. Similarly, learning their business’s risks helps sellers take action before a sale to strengthen these areas and maximize their company’s value.
6. Finalize the Quality of Earnings Report
The last step of the quality of earnings checklist is to prepare the quality of earnings report. In this document, experts compile their findings, including supporting evidence, adjustments made during the analysis, and any identified risks. The recipient can then use this resource to guide their decisions and move through a transaction with confidence.
Quality of Earnings Checklist for Sellers
After receiving a quality of earnings report, sellers can use the findings to improve financial transparency and address issues before going to market. Taking corrective action early may increase buyer confidence and support a smoother transaction process. Below, we list some suggestions for how sellers can utilize their QoE report to strengthen their position during a sale:
- Address financial inconsistencies
- Organize supporting documents
- Improve operational weaknesses
- Prepare explanations for adjustments
- Reduce customer or supplier concentration risks
Quality of Earnings Checklist for Buyers
Buyers use quality of earnings reports to validate a company’s financial performance and identify potential risks before completing a transaction. The report provides insight into whether reported earnings are sustainable and reflective of ongoing operations. Some common ways that buyers use a QoE analysis include:
- Verify sustainable earnings
- Assess cash flow reliability
- Identify financial risks
- Evaluate working capital needs
- Support purchase price negotiations
Conclusion
Whether you are preparing to sell, buy, or invest in a business, a quality of earnings analysis is a useful tool. When performing a QoE analysis, experts at Peak Business Valuation follow a quality of earnings checklist. First, they review financial statements to analyze the business’s revenue quality and expenses. Next, they make adjustments to normalize EBITDA and working capital. Last, they identify financial risks and include these and other findings in the quality of earnings report. Buyers and sellers can rely on this report to better understand the business’s market position and move forward accordingly.
As a quality of earnings specialist, Peak Business Valuation has extensive experience performing QoE analyses. If you have any questions about when or how to obtain a quality of earnings report, reach out to Peak! Begin today by scheduling a free consultation.
