Understanding Quality of Earnings Reports and Financial Due Diligence
Quality of Earnings (“QoE”) reports have become an increasingly important part of business acquisitions. The implementation of SBA SOP 50 10 8.1 has brought even greater attention to QoE reports by establishing new requirements for certain SBA-financed business acquisitions.
But what exactly is a Quality of Earnings report, and how does it fit into the broader due diligence process?
A QoE Is Part of Financial Due Diligence
A Quality of Earnings report is a component of financial due diligence. It should not be confused with a comprehensive due diligence investigation.
A business acquisition may involve several different types of due diligence, including legal, financial, human resources, operational, and information technology or technological due diligence. Each addresses different aspects of the business and different risks associated with the proposed acquisition.
Financial due diligence focuses primarily on the target company’s historical financial performance, accounting processes, financial reporting, and the quality of its earnings.
Buy-side financial due diligence is performed for a prospective buyer or lender and includes an investigation of the target’s accounting processes and historical financial trends. Sell-side financial due diligence is generally focused on preparing the seller for the buyer’s due diligence process and identifying financial issues that may arise during a transaction.
Financial due diligence procedures essentially deconstruct the company’s financial reporting to help identify significant issues, risks, trends, and opportunities that may not be apparent from reviewing financial statements alone.
What Is a Quality of Earnings Report?
A Quality of Earnings report is a financial due diligence report focused on understanding the company’s historical earnings and the factors that produced those earnings.
The objective is not simply to verify a company’s reported EBITDA or identify discretionary expense add-backs. A QoE seeks to develop a deeper understanding of the business, its operations, accounting practices, financial history, and operating environment and how these factors have affected its earnings.
Several areas are typically important to this analysis.
Revenue Generation. Understanding how the target generates revenue is fundamental to understanding its earnings. This may include reviewing the company’s market and competitive environment, revenue recognition policies, pricing, contractual terms, customer base, customer concentration, sales volume, and product or service mix.
Key Performance Indicators and Earnings Trends. Financial due diligence examines historical revenue, gross profit, margins, EBITDA, and other relevant financial and operating trends. Key performance indicators may also be evaluated against historical company performance or relevant industry benchmarks. The objective is to identify the factors that have driven changes in the company’s financial performance.
Quality of Earnings. Reported EBITDA is only the starting point. A QoE analysis may identify nonrecurring income and expenses, owner-related expenses, related-party transactions, unusual accounting adjustments, changes in margins, customer gains or losses, and other matters affecting reported earnings. These procedures help the buyer or lender understand the company’s normalized historical earnings.
Operating Expenses and Cost Structure. A QoE also considers the company’s operating expense and cost infrastructure. Understanding labor, overhead, gross margins, occupancy costs, and other significant expenses helps explain historical profitability and identify significant cost trends or anomalies.
Balance Sheet and Working Capital. The income statement does not tell the entire financial story. Financial due diligence may also include analysis of accounts receivable, accounts payable, inventory, accrued expenses, deferred revenue, capital expenditures, and other operating assets and liabilities. Understanding historical working-capital requirements can be particularly important when evaluating the economics of an acquisition.
Why Quality of Earnings Matters
Two companies can each report $1 million of EBITDA while having substantially different earnings quality.
One may have recurring revenue, diversified customers, consistent margins, reliable accounting records, and stable monthly results. The other may have significant customer concentration, volatile margins, aggressive accounting practices, weak financial reporting systems, or substantial year-end adjustments.
A traditional financial statement may not fully reveal these differences. A Quality of Earnings analysis is intended to provide the buyer or lender with greater insight into the economic performance underlying the reported numbers.
A QoE does not predict or guarantee future performance. Rather, it helps the user understand how historical earnings were generated, the trends and risks affecting those earnings, and their relevance when evaluating the business being acquired.
SBA SOP 50 10 8.1 and Quality of Earnings
Effective October 1, 2026, SBA SOP 50 10 8.1 introduced a Quality of Earnings requirement for certain SBA-financed business acquisitions. For transactions meeting the applicable SBA requirements, an independent QoE report must be obtained as part of the lender’s underwriting process.
Importantly, a Quality of Earnings report and a business valuation serve different purposes.
A business valuation addresses the value of the business. A Quality of Earnings report examines the historical financial performance and quality of the earnings underlying the transaction.
The SBA’s increased emphasis on Quality of Earnings highlights the importance of reliable accounting information and independent financial analysis in acquisition lending.
The Bottom Line
A Quality of Earnings report is more than an adjusted EBITDA calculation. It is a financial due diligence tool designed to provide a deeper understanding of how a company generates revenue, its historical earnings and trends, operating cost structure, accounting practices, balance sheet, and working-capital requirements.
For buyers and lenders, that analysis can provide valuable insight into the quality of the historical earnings being acquired and relied upon to support the transaction.
