Quality of Earnings Analysis

Quality of earnings (QoE) analysis strips reported financials down to the economic reality underneath. A company reporting $15M in revenue and $3M in EBITDA may have a very different economic reality once you adjust for non-recurring revenue, related-party transactions, owner compensation normalization, and aggressive accounting practices. The QoE is the number the acquirer actually pays for — not the number on the P&L. Every due diligence process begins here.

1. Revenue Adjustments Remove non-recurring revenue: one-time implementation fees, contract buyouts, unusually large deals that will not repeat. Normalize for timing: was revenue pulled forward from future periods through aggressive recognition? Was a multi-year contract booked as lump-sum instead of ratably? After adjustments, you have the "run-rate" revenue — the revenue the business will generate going forward under normal operations.
2. Expense Adjustments Normalize owner compensation to market rate (many owners under- or over-pay themselves). Add back non-recurring expenses: one-time legal fees, restructuring costs, pre-acquisition bonuses. Remove expenses that will not continue post-acquisition: redundant roles, owner perks, non-operational expenses. The adjusted EBITDA is the earning power of the business in new hands.
3. Working Capital Normalization Analyze working capital trends over 24 months. A seller who collects aggressively and delays vendor payments before the sale is inflating the cash position artificially. Normalize working capital to the trailing 12-month average. Any shortfall below normal is a liability the buyer inherits.