Key aspects of a QoE and why it is crucial for a searcher

A Quality of Earnings (QoE) report is a critical component of the DD process when acquiring a company, as it allows the searcher to verify the true financial performance and sustainability of the target company. The process should be carried out after signing the LOI, and the findings will influence on the price, on the deal structure, the financing terms and post-close priorities.

It goes beyond standard accounting statements (such as the P&L or balance sheet) to uncover any financial risks that could affect valuation or deal terms. QoE refers to the sustainability, reliability, and accuracy of a company’s earnings, as opposed to earnings that may be artificially inflated by accounting practices, one-time events, or non-recurring sources of income.

It’s crucial for a searcher, as it allows them to limit the margin for error, increase investor confidence, and improve operational readiness. It helps them understand what kind of business they are really stepping into, from both a financial and strategic standpoint.

The main objectives of a QoE are:

1/ Validate EBITDA and normalized earnings:

• Adjust for non-recurring, one-time, or unusual revenues/expenses.
• Normalize owner compensation or related-party transactions (non operating expenses).
• Ensure that reported EBITDA accurately reflects the operational profitability of the business going forward.

2/ Assess revenue quality:

• Analyze customer concentration risk: breakdown by Customer, product/service, geography…
• Identify recurring vs. project-based or one-off revenues.
• Evaluate seasonality, contract terms, and deferred revenues.

3/ Analyze expense trends & working capital:

• Detect cost anomalies, margin consistency or misclassifications.
• Evaluate inventory practices (excess or obsolete), supplier relationships and dependencies, and cost controls.
• Assess working capital needs and changes that could impact cash flow post-acquisition.
• Identify under or over investments in staffing, marketing or R&D.
• Look for expense shifting between periods.

4/ Evaluate cash flow and FCF:

• Analyze how much of EBITDA converts to cash.
• Highlight capex requirements and debt servicing needs.
• Identify adjustments for cash vs. accrual accounting.

5/ Detect accounting irregularities or aggressive practices:

• Uncover risks such as premature revenue recognition, improper capitalization of costs, or overstated assets (inventory valuation, write-downs…).
• Identify the use of reserves or accruals to smooth earnings.
• Note any pending litigation or contingent liabilities.

6/ Strategic insights:

• Profitability of different customer/product segments.
• Business model sustainability.
• Opportunities for margin improvement.
• Industry benchmarking.
• Operational KPI analysis and financial red flags.

7/ Support valuation and negotiations:

• Help the searcher justify (or challenge) the purchase price based on adjusted and normalized financials.
• Strengthen the position when negotiating earn-outs or indemnities.

The typical scope of a QoE report should include an executive summary of key findings, a reconciliation of reported versus adjusted EBITDA, revenue (by product, customer, geography…) and cost analysis, working capital trends, capex and cash flow review, balance sheet observations, and the identification of key risks or areas requiring further investigation.