Quality of earnings, explained

A quality of earnings report, or QoE, is a diligence report that tests whether a company's earnings are real and will repeat. A buyer, a private equity or growth investor, or a lender hires an accounting firm to prepare it; a seller sometimes commissions its own first, called a sell-side QoE.

It isn't an audit and gives no opinion. It's a set of analyses the deal is priced on.

Adjusted EBITDA. The report starts from reported EBITDA and adjusts it: errors and cutoff problems found in diligence, one-off costs like a lawsuit or a failed acquisition, and pro forma changes such as a price increase or a hire already made. Each adjustment is supported, or the buyer won't accept it.

Net working capital. It sets a normal level of working capital, usually excluding cash and debt and often based on a trailing twelve-month average. That level becomes the peg in the purchase agreement, and the price is adjusted at closing for the difference between it and what's actually delivered.

Proof of cash. It ties each month's bank deposits and payments to reported revenue and expenses, which is how a reviewer finds revenue that never turned into cash. It also looks at customer concentration, deferred revenue and debt-like items such as unpaid bonuses and taxes.

A company reports $5 million of EBITDA. The QoE finds $300,000 of December bills booked in January and adds back $200,000 of one-off legal costs. Adjusted EBITDA is $4.9 million, and at ten times EBITDA that's $1 million off the price.