Quality of Earnings
Buy a BusinessA Quality of Earnings (QoE) analysis is the single most important piece of due diligence when buying a business. It answers the question the seller’s add-backs always dodge: “Of the earnings you claim, how much is real, recurring, and will survive the day I take over?” Without a QoE, you are buying a story; with one, you are buying a cashflow stream.
How it works. A QoE — typically performed by a CPA or transaction advisor — examines the company’s financials line by line. It verifies revenue (are there one-time clients, related-party sales, or contracts ending soon?), scrutinizes every add-back (is that “personal” expense truly discretionary, or will a new owner incur something similar?), analyzes customer concentration (if two clients represent 60% of revenue, the earnings are fragile), and normalizes for industry-standard expenses the current owner may have skipped.
The most common QoE findings that kill deals: (1) the seller’s “SDE” includes salary for family members who don’t actually work, (2) revenue includes non-recurring projects that won’t repeat, (3) expenses have been deferred (deferred maintenance, skipped software upgrades) that the buyer will inherit, and (4) the business has heavy customer concentration that makes the earnings stream brittle. Every one of these turns a “profitable” business into a break-even or worse.
A thorough QoE also tests the working-capital requirements, examines owner replacement cost (what salary must you pay a manager to do what the seller did?), and produces a “normalized EBITDA” or “adjusted SDE” — the number you actually underwrite to. For the full process, see due diligence and quality of earnings.