When business owners reach the negotiation phase and first hear the phrase “quality of earnings analysis,” they may not know the term's nuances. What they do know is that “QoE” followed by “issues” means that the buyer now has leverage to negotiate for a lower price.
In this article, I’m going to break down QoE and stick to what you need to know as a business owner—no more, no less. Let’s get going.
Why do we talk about QoE so much, and what does QoE analysis actually do to close a sale?
When we conduct a QoE analysis, we’re not doing it to produce documents. QoE analyses are simply a way to answer buyers' pressing questions clearly.
Take a look at the questions below. There’s a lot at stake.
- What is your profit margin after adjusting EBITDA for one-time events, owner perks, and other items?
- How well does your business manage working capital?
- What is the gap between profit on paper and cash in your accounts?
- Is your revenue durable? Is it recurring? Where does it come from?
If you’re still thinking about QoE as an isolated, technical process, then make a clean break with that thinking right now. It’s not useful for business owners.
A Quality of Earnings (QoE) analysis shows what a business earns and how much cash it needs to keep earning it. It is not an audit, and it is not a valuation. It is a financial health check for your business.
I often say things like “we bring the numbers” when talking about due diligence and QoE.
Forget about the numbers. I’m not telling you that numbers make deals. I’m telling you that uncertain, fearful, and greedy buyers kill deals.
A thorough QoE analysis gives them what they want and need: information to calculate risk and a reason to accept the terms of a square deal instead of quibbling over dollars and cents.
Negative QoE findings are a leading deal killer, and that’s not an opinion.
Industry surveys cite quality-of-earnings findings as the primary culprit behind this startling statistic: 30 to 50 percent of letter-of-intent-stage deals are renegotiated down. Overinflated valuations are another reason, and surveys also suggest they're tied to inaccurate revenue numbers. QoE quickly exposes those revenue numbers.
- Across M&A deals worldwide, diligence timelines have stretched to roughly 203 days on average.
- Sell-side reviews routinely surface anywhere from $100,000 to more than $1 million in EBITDA adjustments.
- Every one of those adjustments lands after the letter of intent is signed, meaning each one is a one-sided conversation.
A business that arrives at diligence trading on a 7x multiple can watch that multiple compress to 5.5x on the strength of a few unflattering discoveries. For a firm with $4 million in EBITDA, that’s the difference between $28 million and $22 million.
The data is clear: Business owners play defense when QoE is not prioritized.
Normalized earnings drive growth decisions, not just transaction readiness.
A comprehensive QoE analysis uses a financial metric called “normalized earnings.” Normalized earnings represent your company’s profits after removing the impact of one-time events, unusual expenses, and seasonal fluctuations. Think of it as a “true” earnings number for your company.
It’s a key metric across industries:
- Lenders use normalized earnings to assess whether to extend a line of credit to a business.
- Prospective partners scrutinize normalized earnings before writing a check.
- Business owners look at normalized earnings at key decision points: when to commit to an expansion, take on debt, or bring a family member into the ownership structure.
Yearly QoE analysis prepares owners for transactions, but that’s not nearly the extent of its value.
QoE is a big player in due diligence and transaction readiness, of course. What’s underrecognized about QoE analysis is its impact on internal controls, operations, and financial planning:
- Catches cash-versus-accrual gaps.
- Puts a spotlight on declining customer relationships.
- Shows where the fat is and when to make the cut.
When a banker hesitates on a credit request, or a wealth manager asks how dependent the business is on you personally, they are asking the same questions a QoE answers directly.
Owners who can offer accurate normalized earnings in those conversations tend to get further than owners who haven’t done the math.
Customer concentration is a small example of a big idea.
Where does your revenue come from? Owners rarely feel at risk when a single customer represents a large share of their revenue. They tend to view that as a good customer relationship. Buyers look at it as exposure. What happens if that customer goes elsewhere?
Buyers look to reduce multiples when a single customer hits 20% of revenue, and some decline opportunities above 30%. Valuation discounts commonly range from 20% to 35%.
Generally Accepted Accounting Principles (GAAP) in the United States require public companies to disclose when a single customer represents 10% or more of total revenue. Private buyers apply the same lens, with discounts to match.
Here’s the upside: If we take on a proactive mindset and perform a rigorous QoE analysis now, then we can make business decisions that address the issue. At a minimum, we can provide a clear explanation to a concerned buyer.
Standard revenue reports may miss a critical metric: customer revenue share.
In one deal I read about recently, a QoE analysis revealed that a customer the seller reported at 20% of revenue was actually responsible for more than 60% once inter-company transactions were untangled. That discovery ended the transaction.
An owner who had seen that number three years earlier could have spent those years diversifying. An owner who sees it for the first time across the table can only absorb the discount.
We make QoE a habit, not a fire drill.
The business owners who sell well, borrow well, and grow well already know what a QoE would find, because someone regularly runs the analysis for them. You don’t have to run the full, buyer-grade exercise every year.
A lighter annual review of normalized earnings, working capital, revenue quality, and revenue share is sufficient.
Understanding your quality of earnings gives you more options, not just when it’s time to sell, but throughout the life of the company. Lenders will ask about it. Potential partners want to see it. Most importantly, a QoE analysis reveals exactly how healthy your business is.
Seeing your numbers the way a buyer would requires a long-term M&A advisory partner.
Have you ever seen your own numbers the way a buyer’s team would? It is one of the most clarifying exercises an owner can go through, whether a sale is five years away or not on the horizon at all.
Understanding and improving what the buyer will find requires a partner who has been in the room for years, combining CFO-level financial analysis, M&A advisory, and tax planning. We’d like to be that partner.
To get started, schedule a discovery call.
Justin Machado, CEPA®
Accounting Manager
The Novyx Group
