Quality of Earnings Review: What It Covers & Why

Quality of Earnings Review: What It Covers and Why It Matters

A company can report healthy profits and still have financial weaknesses that affect its value. Revenue may include unusual sales, costs may be shifted between periods, or earnings may not turn into dependable cash flow. These issues often surface during a business sale, acquisition, financing request, or investor review.

A quality of earnings review, often called a QoE review, looks beneath the headline profit figure. It examines how earnings were produced, whether they came from normal operations, and how likely they are to continue. For buyers, it can reveal risks that affect price or deal terms. For sellers, it can reduce surprises.

What Does a Quality of Earnings Review Mean?

A quality of earnings review examines the financial activity behind a company’s reported profit. Rather than relying solely on net income or adjusted EBITDA, the analysis traces those figures back to the underlying transactions, reporting decisions, and business conditions that influenced them.

The process may cover revenue, expenses, adjusted EBITDA, working capital, cash flow, accounting practices, and internal controls. Its purpose is to estimate the level of earnings the business may be capable of producing during normal operations.

Why Companies Request a Quality of Earnings Review

Businesses often use QoE reviews during acquisitions, private equity transactions, lending discussions, or ownership transitions. A buyer may request one to determine whether the valuation is supported by recurring financial performance.

Sellers may complete a review before going to market so management can organize records, support adjustments, and correct reporting issues before buyer due diligence begins.

The review is especially useful for franchise businesses. Multi-unit operators may have several entities, locations, and intercompany transactions. Consolidated statements can hide major differences between individual units.

Financial Topics Commonly Reviewed in a QoE Engagement

Revenue Recognition

The reviewer studies how and when sales are recorded. Invoices, point-of-sale reports, customer agreements, bank deposits, and accounting entries may be compared to confirm that revenue belongs in the proper period.

The analysis may identify early recognition, unusual year-end sales, one-time contracts, or revenue unlikely to continue. Franchise operators may also provide sales by location or channel.

How Expenses Are Recorded

The review looks at whether costs are assigned to the right period and financial statement line. Misclassification can change gross profit, operating margin, and EBITDA even when total expenses remain unchanged.

Analysts may examine owner-related costs, legal bills, launch expenses, temporary staffing, consulting fees, or repairs. They also consider whether expenses described as unusual are likely to appear again as part of running the business.

EBITDA Adjustments

Adjusted EBITDA often influences valuation, so proposed adjustments receive close attention. Each add-back should have documentation and a clear business reason.

An expense tied only to the current owner may be appropriate to remove. Recurring maintenance, management compensation, marketing, or payroll usually requires different treatment.

Working Capital

Working capital affects how much cash the buyer may need after closing. The review usually examines receivables, inventory, prepaid expenses, payables, accrued costs, and seasonal patterns.

Needs may differ by franchise location. A restaurant may collect revenue immediately but carry inventory and payroll obligations, while a service unit may face slower collections.

Cash Flow

Reported profit does not always reflect available cash. Earnings may be tied up in receivables, inventory, debt payments, or capital spending.

A QoE review compares accounting profit with operating cash flow and investigates major gaps. This shows whether the company consistently produces usable cash or depends on borrowing and owner contributions.

Financial Controls

The reviewer may consider bank reconciliations, approval procedures, payroll access, month-end closing routines, user permissions, and oversight of accounting systems.

Weak controls do not prove the numbers are wrong, but they increase the risk of errors or inconsistent reporting.

Quality of Earnings Review Compared With a Financial Audit

A financial audit and a QoE review answer different questions.

An audit evaluates whether financial statements are presented under the applicable accounting framework. A QoE review is more transaction-focused. It analyzes the sources of earnings, recurring profitability, cash conversion, working capital needs, and unusual items.

An audit may support confidence in financial reporting, but it does not replace a QoE review when a buyer wants to understand future earning power and deal-specific risk.

Advantages for Buyers

For buyers, the review provides a clearer basis for evaluating the purchase price. It can confirm normalized EBITDA, identify cash flow pressure, expose concentration risk, and influence valuation, financing, or working capital terms.

Advantages for Sellers

For sellers, a sell-side QoE review can make the transaction more organized. It gives the company time to address bookkeeping problems, explain unusual activity, support legitimate EBITDA adjustments, and reduce delays.

Issues Often Discovered During a QoE Review

Common findings include sales recorded in the wrong period, unsupported add-backs, inconsistent expense coding, owner costs mixed with business expenses, overdue receivables, obsolete inventory, unrecorded liabilities, and incomplete reconciliations.

A review may also reveal dependence on one customer, location, supplier, or owner. Recent growth may come from temporary pricing, delayed spending, or favorable conditions rather than lasting improvement. The impact depends on size, frequency, evidence, and future effect.

Getting Ready for a Quality of Earnings Review

Preparation begins with records that can be traced back to supporting documents. Bank accounts, credit cards, payroll, debt balances, receivables, payables, and intercompany accounts should be reconciled.

Financial statements should agree with tax returns and detailed schedules. Management should document unusual transactions, proposed EBITDA adjustments, and owner-related expenses.

Franchise operators should also prepare location-level statements, sales reports, royalty records, lease obligations, payroll data, and shared-cost allocations.

The objective is to present the company’s financial position clearly and explain changes in revenue, margins, labor, cash flow, and operating costs with reliable documentation.

How QMK Consulting Supports the Process

QMK Consulting helps franchise owners, multi-unit operators, buyers, and sellers understand the performance behind reported earnings. Our team reviews cash flow, working capital, location results, expense trends, controls, and adjustments that may affect value. We also help organize records and prepare management for due diligence questions.

Frequently Asked Questions About QoE Reviews

How Would You Describe a Quality of Earnings Review?

It is an analysis of the financial activity behind reported earnings to determine whether profits are recurring, supportable, and connected to normal business operations.

Who Usually Carries Out the Review?

Accounting, transaction advisory, financial due diligence, or valuation professionals typically perform QoE work.

What Affects the Timeline?

Timing depends on the size of the company, number of locations or entities, condition of the records, and scope requested by the buyer or seller.

Must a Business Complete One Before a Sale?

A QoE review is not legally required in most business sales. However, buyers, lenders, and investors may request one, and sellers may order one in advance to reduce uncertainty during negotiations.

Understand the Numbers Before a Major Decision

A quality of earnings review can reveal whether reported profit reflects dependable operations or temporary financial effects. It helps buyers evaluate risk, gives sellers a stronger due diligence position, and supports better decisions about valuation, cash flow, and growth.

QMK Consulting provides franchise owners with a complimentary profit and cash flow review designed to show where performance is strong, where cash may be under pressure, and which financial areas deserve closer attention. Connect with our team before your next acquisition, sale, financing request, or expansion decision.