What a Quality of Earnings Analysis (QoE) Uncovers in a Deal

A quality of earnings (QoE) analysis validates whether a company's reported EBITDA is earned, recurring, and defensible, not just whether the math adds up. It examines revenue quality, customer concentration, churn, contraction, unit economics, and margin by business line and product. For sellers and buyers in the lower-middle market, understanding the quality of revenue and the quality of earnings is the difference between a defensible number, sound valuation, and investment thesis and a bad deal.

A car can look flawless from the outside, but that doesn't mean it's never been in an accident or doesn’t have any warning lights on its dashboard. A quality of earnings (QoE) analysis is the equivalent of popping the hood: checking the engine, the fluids, the valves, and understanding what lights are on or should be on before the title changes hands. A business is no different. 

Most PE investors grow a platform through some combination of organic and inorganic growth. The inorganic piece is add-on acquisitions: bolting a smaller business onto an existing platform. Add-ons create value on day one, through EBITDA multiple arbitrage and the operational synergies of folding a smaller, less-resourced business into the larger platform.

That opportunity usually comes from one of two places: through an investment banker, sell-side advisor, or broker, or sourced directly, typically after multiple attempts and meetings over an extended period. Either way, the data available before an offer and letter of intent is usually limited and heavily redacted. The investor is left working from headline financials or basic customer cube data to build an offer and get it approved by the investment committee.

For example, Exbo Group recently performed a QoE analysis on a managed service provider (MSP) business that looked textbook on paper: strong revenue, no customer concentration issues, solid retention. Add back interest expense, income taxes, depreciation, and amortization on $700,000 to $800,000 of net income, and you get a definitionally adjusted EBITDA of $1.2 million. Most sellers would put that number in front of a buyer, but it’s the wrong number to build a deal on.

What the P&L doesn’t show at face value

When we broke the business down by business line, a vastly different picture emerged. The core services piece, the IT support and retainer-based work, was underwater. We calculated this by taking their monthly retainers (recurring revenue) and subtracting the cost of the workforce supporting that line. In other words, staffing it cost more than the business collected in retainers, creating a dependency on their other revenue streams and leaving the business exposed if market conditions in that line shifted. 

The company was profitable on paper only because two other revenue lines covered for it: roughly $3 million a year in project-based work, and a high-margin software sales line, which was being blended into their full offering. Take either of those away, and the retainer business alone would drive the business into the red.

The question and perspective have to shift for the investor to understand the nature and expected recurrence of the project-based work: can we confidently underwrite this type of work continuing indefinitely with the same customer base, or will there be contraction, and what happens to the software sales line amid the pricing pressure software companies and resellers are under industry-wide?

The quality of earnings is not just EBITDA adjustments

There's a common misconception that a QoE analysis is just about getting to diligence-adjusted EBITDA. Adjusted EBITDA is indeed a byproduct of the QoE process, but it isn’t everything. QoE is an assessment of whether a target company's earnings are reliable and sustainable, and what the business looks like in its steady state, often referred to as a company’s “normalized earnings”. Adjusted EBITDA gives an investor a figure, but it doesn’t calibrate the risk associated with that figure.

The changes to reported earnings, including one-time items, non-business-related transactions, owner compensation, and lease terms brought to market rate, are part of the process, typically referred to as diligence adjustments. 

The adjustments aren't the only point, though. What matters is the question they exist to answer: can you underwrite this $1.2 million of EBITDA, or does it evaporate if one revenue stream slows down, or one of their top customers leaves? Or if they are dependent on a specific vendor to provide supplies that would change their economics if they went out of business or increased their prices, that could not be passed through to their customers.

It all starts at the top, and that’s why we spend so much time examining the quality of revenue, to try to answer how sustainable the business is. Is the revenue recurring or transactional? What's the churn rate and the underlying reason for churn, the contraction, and the customer concentration? What does it cost to acquire a customer, and what's the lifetime value once you have one? What's the realization on contracts, and where does gross margin sit once you separate the business into its individual components rather than treating it as one blended number? Two businesses can have the same EBITDA line and not be worth the same, depending on the answers to those questions. 

Recurring revenue could be growing, but that growth could be propped up by heavy marketing spend and hide high churn behind a constant stream of new customers replacing the ones who leave. That raises a bigger question about total addressable market: how long can this growth continue before the business stalls and starts losing ground? Private equity investors aren't in the business of trying to catch a falling knife.

How the process works

In the lower-middle market, sub-$100 million in enterprise value, most companies are running some composite of cash-basis books. Transactions hit the bank account, and that's what shows up as revenue, whether or not the service has actually been delivered or the revenue has actually been earned. That's different from the middle market and above, where there's typically a full finance team, GAAP-based accrual accounting, and audited financials on file.

So the process starts by moving reported financials to accrual, using standards like ASC 606 to determine when revenue should be recognized. From there it moves to a diligence set, then to a pro forma view. Each step has its own logic, and the adjustments that carry the most scrutiny, payroll chief among them, have to hold up when a buyer's team pushes back.

Why the seller who prepares comes out ahead

There's a meaningful difference between what a buyer wants out of a QoE and what a seller expects going in. A sell-side QoE works the same way as a home inspection before you list your house: it reveals improvements to make that would add value. This then gives the seller the option to move as quickly or as slowly as they want when they go to market. The goal is to identify the risks and trends, then build the story and the plan that maximizes enterprise value. 

In the MSP business example, nothing was hidden or dishonest. The owner likely believed the $1.2 million EBITDA number was accurate, because on a standard P&L, it was. A QoE isn't about catching bad actors. It's about finding out, before anyone else does, whether a business’s earnings can hold up once a buyer's diligence team starts pulling them apart.

The MSP's owner didn't get that answer until a buyer found it for him. Sellers heading toward a transaction in the next year or two still have time to get there first.

For our client on the buy-side, we delivered the risks we identified, and the adjusted EBITDA figure we believed was correct, giving the investor the tools they needed to determine the right next step.

How Exbo approaches QoE analysis

Exbo's Transaction Services practice runs QoE for buyers and sellers in the lower-middle market. If you're heading toward a transaction and want a clear picture of what a QoE would surface for your business, reach out to Exbo's team.

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FAQs

What is the difference between EBITDA and quality of earnings?
EBITDA is a calculation. Quality of earnings is an assessment of whether that calculation reflects a business's underlying, sustainable performance. It looks at revenue recurrence, customer concentration, and margin by business line rather than just the reported number.

When should a seller get a quality of earnings analysis?
Ideally, 6 to 24 months before going to market, well before engaging with buyers. Waiting until after a letter of intent puts the seller on defense, responding to the buyer's findings instead of presenting a prepared package.

Why do lower-middle market companies need to convert to accrual accounting for a QoE?
Most companies under $100 million in enterprise value run cash-basis books, where revenue reflects when cash hits the account rather than when it's actually earned. A QoE moves those financials to accrual using standards like ASC 606 so the earnings picture reflects reality instead of timing.

What are the biggest red flags a quality of earnings analysis can expose?
Customer concentration, high churn, low realization on contracts, and blended margins that look healthy on the surface but hide an unprofitable core business line, the kind of problem that only shows up once you break a company down by cohort instead of looking at the P&L as a whole.

Does a quality of earnings analysis only benefit buyers?
No. Sellers who commission their own QoE before going to market get to identify and defend the adjustments themselves. That protects purchase price and negotiating leverage, ensuring you can find any gaps before a buyer's diligence team does.