Quality of Earnings, explained.

What is a Quality of Earnings?

A Quality of Earnings (QofE) is an independent analysis of a company’s historical earnings. It answers two questions: are the earnings real, and how much can you rely on them going forward?

Sellers and brokers usually present a business on its adjusted EBITDA, along with a list of adjustments. A QofE tests that number. It ties the financials to the bank, removes items that don’t belong, keeps the adjustments that hold up, and shows the result as a bridge from reported to adjusted EBITDA. It also looks past EBITDA to the things that change what you actually pay at closing: working capital, debt, and debt-like items.

In the end, a QofE is about confidence. Buyers, lenders, and investors use it to decide how much they believe the numbers, and sellers use it to earn that belief before diligence starts.

Two words, two questions

The name says what it does. Each word asks something different.

That second word is the biggest difference between a QofE and an audit. An audit asks whether the financial statements are fairly presented. It doesn’t ask whether the earnings are sustainable, or how much a buyer should rely on them.

QofE vs. audit vs. valuation

These three get confused often. They answer different questions.

They work together. A valuation relies on earnings it can trust, and the QofE is often where that trust comes from. Two businesses with the same EBITDA can be worth very different amounts, and the difference usually comes down to quality.

What is adjusted EBITDA?

EBITDA is earnings before interest, taxes, depreciation, and amortization. It approximates the cash a business generates from operations, regardless of how it’s financed or taxed. Adjusted EBITDA goes a step further and normalizes for items that won’t continue the same way under a new owner.

We call these adjustments, not add-backs, because they can go either way. Removing the owner’s personal expenses increases EBITDA. But an owner paying themselves below market, or renting the building from a related party below market rent, means EBITDA has to come down to reflect what those costs will really be.

Adjustments that usually hold up

• Truly one-time costs with documentation, such as a lawsuit settlement or a one-off system migration
• Personal expenses clearly run through the business
• Owner compensation brought to what it would cost to hire a replacement, in either direction
• Related-party rent brought to market rates

Adjustments that usually get challenged

• “One-time” costs that show up every year
• Owner salary removed entirely, with no cost for the person who will do that job
• Pro forma revenue or cost savings that haven’t happened yet
• Adjustments with no support beyond the seller’s word

Adjusted EBITDA vs. SDE

Smaller owner-operated businesses are often marketed on seller’s discretionary earnings (SDE), which adds back one working owner’s entire salary and benefits. Adjusted EBITDA instead deducts what it would cost to pay someone to do the owner’s job. That means adjusted EBITDA is always lower than SDE.

If you’re buying on SDE, keep this in mind: your lender will underwrite on adjusted EBITDA, and that lower number has to cover the loan payments with room to spare. Lenders measure that cushion as a debt service coverage ratio (DSCR), often 1.25x or higher. A business with $800,000 of SDE and a $150,000 market salary for the owner’s role has about $650,000 of adjusted EBITDA, which supports roughly $520,000 of annual debt service at 1.25x. Price the deal on SDE alone and the loan may not fit.

What a QofE covers

• Adjusted EBITDA bridge. Every adjustment from reported to adjusted earnings, with the support behind it.
• Proof of cash. Revenue and expenses tied to actual bank activity. If the P&L and the bank don’t agree, you need to know why.
• Net working capital. The normal level of receivables, inventory, and payables the business needs to run. It sets the working capital target (the “peg”) in the purchase agreement. If the seller delivers less than normal, you pay the difference.
• Debt and debt-like items. Obligations that reduce what the equity is worth, such as deferred revenue, customer deposits, unpaid bonuses, past-due taxes, and equipment financing.
• Revenue quality. Trends, customer concentration, recurring versus one-time revenue, and whether revenue is recorded in the right period.

Who needs one?

• Buyers and searchers. You’re about to commit your capital, and often a personal guarantee, to the earnings in the seller’s numbers. A QofE tells you whether they’re real and how predictable they are before you’re locked in.
• Lenders. As of October 1, 2026, SBA 7(a) acquisition loans with a business purchase price of $3 million or more require the lender to obtain a QofE. Here’s what that rule means. Many conventional lenders expect one too.
• Private equity and independent sponsors. Capital partners and investment committees expect a QofE before they fund a deal.
• Sellers. This is where we see the most untapped value. A sell-side QofE finds issues before a buyer does, while you still have time to fix or explain them. It gives buyers confidence in your numbers from the first conversation, which means faster diligence, fewer surprises, and fewer attempts to renegotiate the price. Buyers and lenders will still do their own work, but they start from numbers that have already been tested.

When to get one

Buyers: most order a QofE after signing an LOI, during exclusivity, and before final financing. The earlier a material finding surfaces, the more options you still have to renegotiate, restructure, or walk. On SBA deals, that means getting the QofE underway as soon as the term sheet is accepted.

Sellers: before going to market, with enough time to fix what it finds.

Cost and timeline

Our engagements are scoped to the question you need answered.

Cash Proof credits in full toward Validation, Lite QofE, or Full QofE if you engage within 30 days. Pre-QofE (and Validation, if completed) credits in full toward Full QofE within 30 days. Prices reflect standard scope. Final scope, pricing, and terms are set in a signed engagement letter. These engagements are not an audit, review, or compilation and are not designed to detect fraud.

See the full scope of each on our Services page, or get the Service Menu and sample work.

Common red flags

Issues we see often in lower-middle-market deals. Many diligence reviews stop at EBITDA, but working capital, debt-like items, and the balance sheet are where a lot of purchase price quietly moves.

Earnings

• Revenue on the P&L that doesn’t match deposits in the bank
• Adjustments with no documentation behind them
• A single customer driving a large share of revenue
• Margins that improve sharply right before a sale
• Books kept on a cash basis, which can shift revenue and expenses between periods

Net working capital

• Old or uncollectible receivables still counted at full value
• Obsolete or slow-moving inventory, or inventory that hasn’t been physically counted
• Payables stretched or collections pushed in the months before closing, which flatters cash
• A working capital peg set from a single month-end in a seasonal business

Debt and debt-like items

• Customer deposits or deferred revenue for work the buyer will have to deliver
• Unpaid bonuses, commissions, or accrued vacation owed to employees
• Past-due income, payroll, or sales taxes
• Equipment loans, financing leases, and related-party loans
• Deferred maintenance or overdue equipment replacement the buyer will have to fund

Balance sheet

• Bank and loan balances that don’t reconcile to statements
• Personal assets, or amounts owed by the owner or related parties, sitting on the books
• Missing accruals, so liabilities are understated and earnings overstated
• Balance sheet accounts that haven’t been reconciled in months

See real examples in our sample Red Flags Report.

Frequently asked questions