Quality of Earnings Report: What Business Owners Need to Know Before a Sale

When you are preparing to sell your business, the profit shown in your accounts is only part of the picture.

A serious buyer will want to understand how sustainable those earnings are, how reliably they convert into cash and whether the figures presented genuinely reflect the underlying performance of the business.

That is where a quality of earnings report, often shortened to QoE, becomes important.

For you as the seller, understanding the quality of your earnings before a buyer starts asking questions can make a real difference. It gives you the opportunity to explain legitimate adjustments, address weaknesses and enter negotiations with a clearer view of the earnings a buyer is likely to rely upon.

What Is a Quality of Earnings Report?

A quality of earnings report looks beyond headline profit to assess how much of a company’s earnings are sustainable and repeatable.

It commonly considers areas such as:

• adjusted EBITDA and proposed add-backs
• recurring and non-recurring revenue
• cash generation and cash conversion
• working capital
• unusual costs or income
• consistency of financial reporting.

The key question is not simply “What profit did the business make?”

It is:

“What level of earnings is a buyer likely to regard as maintainable?”

That matters because many business valuations are influenced by a multiple of adjusted or maintainable EBITDA.

Why Does Quality of Earnings Matter When Selling a Business?

A buyer is not buying your historic accounts. They are buying their expectation of what the business can generate after completion.

That means they need confidence that the earnings presented during the sale process can continue.

If an offer is based on £2 million of adjusted EBITDA, but due diligence later leads the buyer to conclude that only £1.7 million is maintainable, they may seek to renegotiate the price or change the structure of the deal.

That does not mean every buyer challenge will be justified. It does mean your adjustments need to be clearly explained and supported.

This is why preparation matters.

You are in a much stronger position if you understand the likely areas of challenge before you enter exclusivity with one buyer, rather than discovering them for the first time during due diligence.

What Does a Quality of Earnings Review Look At?

The exact scope will vary depending on the business and transaction, but there are a few areas buyers commonly focus on.

Adjusted EBITDA and Add-Backs

For many owner-managed businesses, adjusted EBITDA is an important part of the valuation discussion.

The aim is to identify a realistic level of underlying earnings after genuine one-off or owner-specific items have been removed.

This is where judgement becomes important. Buyers will want to see evidence that the adjustment is genuinely non-recurring or will not be required by the business under new ownership.

A long list of aggressive adjustments can weaken rather than strengthen your position.

The strongest approach is usually a defensible one: sensible adjustments, clear evidence and a consistent explanation of how you arrive at maintainable EBITDA.

Of course, if you are going to add back, you should also be prepared to add forward. In other words you may have to include some costs the business does not currently carry, particularly in terms of replacing the day-to-day functions of departing shareholders.

Revenue Quality

Buyers will also want to understand where your revenue comes from and how dependable it is.

They may look at:

• recurring versus project-based revenue
• customer concentration
• customer retention
• changes in pricing, volume or margins
• unusual movements between financial periods.

The more predictable and explainable the revenue base, the easier it is for a buyer to gain confidence in future earnings.

Cash Conversion

Profit and cash are not the same thing.

A business can report strong EBITDA while still absorbing significant amounts of cash through working capital, capital expenditure or slow customer payments.

Buyers will therefore look at whether earnings convert into cash consistently and whether there are obvious reasons for any gaps.

Weak cash conversion does not automatically make a business unattractive. Growing, seasonal or working-capital-intensive businesses may have perfectly reasonable explanations.

What matters is that you understand those movements and can explain them clearly.

Working Capital

Working capital can have a direct effect on the amount you ultimately receive from a sale.

Buyers commonly review debtors, creditors, stock levels and seasonal movements to understand the amount of working capital the business normally requires.

This can then feed into the purchase-price mechanism.

Owners often underestimate this area because a strong cash position at year-end does not necessarily reflect how the business trades throughout the year.

If your working capital fluctuates significantly, you should understand why before going to market.

How Does Quality of Earnings Fit into Due Diligence?

Quality of earnings is usually part of the wider financial due diligence process.

A buyer may also review matters such as net debt, forecasts, balance-sheet exposures and financial controls, alongside separate legal, tax, commercial or operational due diligence.

For the seller, the important point is that issues identified in a QoE review can quickly become commercial issues.

A disputed EBITDA adjustment, unexpected working-capital requirement or concern about customer concentration may influence price, deal structure or negotiations.

That is why due diligence should not be treated as something that simply happens once a buyer has been found.

It should be prepared for in advance.

Do Sellers Need Their Own Quality of Earnings Report?

Not every business sale requires a formal vendor quality of earnings report.

Whether one is appropriate will depend on the size and complexity of the transaction, the likely buyer group and the quality of your existing financial information.

For some sellers, a formal vendor due diligence exercise can help identify potential issues before buyers begin their own work.

For others, a focused review with their advisers and finance team may be sufficient.

The important principle is the same:

Do not wait for the buyer to tell you where the weaknesses are.

Before going to market, you should understand the adjustments behind your EBITDA, the quality of your revenue, how earnings convert into cash and how working capital behaves.

How Should You Prepare?

If you are considering a sale, start by making sure your financial information is clear, current and easy to reconcile.

Ask yourself:

• Can every EBITDA adjustment be supported?
• Can you explain any unusual movements in revenue or margin?
• Is recurring revenue clearly identifiable?
• Do you understand your cash conversion?
• Are working-capital movements predictable and explainable?
• Do your management accounts reconcile with your statutory accounts?

You do not need a perfect business to achieve a successful sale.

But you do need to know where a buyer is likely to ask difficult questions.

Quality of Earnings Is Really About Buyer Confidence

A strong sale process is not built around presenting the biggest possible EBITDA number.

It is built around presenting a credible one.

If a buyer understands your earnings, trusts the supporting information and can see why performance should continue after your exit, they have a stronger basis on which to make an offer.

For you, that can mean fewer surprises during due diligence and a better position from which to defend the value you have built.

If you are considering selling your business and want to understand how a buyer may view your financial performance, speak to the Entrepreneurs Hub team confidentially.