Bridging the Gap: How Quality of Earnings Analyses Define Transactional Clarity and Drive ROI

In today’s transactional landscape the stakes are high, and diligence must be deeper than ever. As valuations surge and deal activity fluctuates across industries, buyers, sellers, and their advisors face a common challenge: discerning real, sustainable profitability from accounting noise. That’s where a rigorous Quality of Earnings (QoE) Analysis plays a critical role.

This article outlines the key facets of QoE reporting and how these analyses deliver return on investment by enabling informed decisions in the M&A process.

The Objective of a QoE Analysis

At its core, a Quality of Earnings Analysis is a deep dive into a company’s true economic earnings. It evaluates the nature, quality, and sustainability of the earnings reported in the financial statements, particularly focusing on adjusted EBITDA (Earnings before Interest , Taxes, Depreciation and Amortization) and operating cash flows.

Unlike an audit, which tests for compliance with accounting standards, a QoE analysis is designed to assess the economic reality of a business. It is forward-looking, highly contextual, and tailored for deal-making. Buyers rely on it to validate assumptions underlying valuation models, while sellers may use it to prepare for scrutiny and defend a premium buy-out price.

QoE analyses often go far beyond the income statement, evaluating revenue recognition practices, discretionary spending, seasonality, working capital normalization, and off-balance-sheet liabilities. These insights allow decision-makers to separate accounting optics from operational performance.

 

What the Income Statement Doesn’t Tell You

Buyers and investors typically begin their review with the target’s financial statements. But surface-level metrics like Net Income or even Adjusted EBITDA often obscure the true economics of a business. GAAP (Generally Accepted Accounting Principles) earnings can be manipulated through aggressive revenue recognition, unsustainable expense reductions, or simply poor-quality internal controls.

The classic example: a business posting healthy net income while experiencing declining cash flow. That’s a red flag, and precisely the kind of dissonance a QoE analysis is designed to expose. It evaluates income quality not by looking at earnings in isolation, but by triangulating them against cash flow performance, working capital movements, and one-time or non-recurring transactions.

Operating Cash Flow and the Quality of Earnings Ratio

Perhaps the most critical measure of earnings sustainability is the Quality of Earnings (QE) ratio, defined as operating cash flow divided by adjusted EBITDA. This metric bridges the gap between income statement performance and actual cash generation. It answers the fundamental question: Is this business generating real, repeatable cash flow or are its profits built on accounting assumptions and accruals?

A QE ratio greater than 1.0 is typically interpreted as high-quality earnings. It means the company’s adjusted EBITDA is more than fully supported by operating cash flow, an encouraging signal to acquirers and investors.

In contrast, a QE ratio below 1.0 suggests earnings may be artificially elevated through aggressive revenue recognition, under-accrued expenses, or inefficient working capital management. In addition, earnings may be largely accrual-based and potentially unreliable.

In M&A due diligence, this ratio is especially valuable because it reveals the convertibility of EBITDA into cash, a key driver of enterprise value. Acquirers are not just buying earnings, they're buying the future stream of cash those earnings are supposed to produce. If a target company consistently posts EBITDA growth but struggles to translate that into cash flow, the acquirer is inheriting operational inefficiencies, liquidity risk, or worse—earnings manipulation.

It’s also important to analyze the QE ratio over multiple periods to understand whether earnings quality is improving or deteriorating. For example, a QE ratio that increases over time could signal maturing billing practices, tighter expense controls, or improved customer payment discipline, all of which enhance enterprise value. Conversely, a declining trend might warrant a deeper look at accounts receivable aging, revenue recognition policies, or non-cash income inflating reported results.

Ultimately, the QE ratio acts as a financial “stress test” on the EBITDA figure. It ensures that what appears to be profit on the income statement holds up under the scrutiny of cash-based performance.

Proactive Value Defense: The Seller's Edge in Preemptive QoE

For sellers, conducting a preemptive Quality of Earnings analysis before going to market can be one of the most value-preserving steps in the transaction lifecycle. Rather than waiting for a buyer’s diligenceteam to dissect their numbers, sellers who proactively commission a QoE analysis are able to take control of the narrative and prevent value erosion before it starts. Preemptive QoE equips sellers with the financial clarity needed to control the narrative, mitigate deal risk, and ultimately secure a more favorable outcome.

Owning the Narrative

When a seller commissions their own QoE analysis, ideally before engaging with investment bankers or marketing the business, they gain control over the financial story told to buyers. This includes articulating normalized EBITDA, explaining working capital trends, and addressing accounting treatments that might otherwise raise red flags.

In contrast, when buyers lead QoE diligence, any adjustments they propose can be naturally conservative, if not punitive. By proactively identifying and adjusting for non-recurring, discretionary, or anomalous items, sellers present a cleaner, well-substantiated earnings profile that increases buyer trust and reduces the temptation to renegotiate based on “diligence surprises.”

Enhancing Valuation Through Preparedness

Buyers pay for certainty. When financials are clearly presented, EBITDA is normalized, and major assumptions are supported by evidence, buyers are more likely to bid aggressively and compete on valuation. A preemptive QoE provides this certainty.

For instance, discretionary spending, such as above-market salaries, family travel, or personal legal expenses, can materially depress EBITDA if left unadjusted. Sellers who quantify and document these adjustments upfront can demonstrate a higher true earnings base, supporting a richer valuation multiple.

Furthermore, a QoE analysis can identify underappreciated strengths such as favorable customer payment terms, high client retention, or minimal bad debt, attributes that justify premium pricing when framed correctly.

Accelerating Process and Reducing Friction

A sell-side QoE streamlines the diligence process for all parties involved. When buyers receive a third-party report that addresses the most common financial concerns (revenue recognition, cash flow conversion, profit margin sustainability) they are less likely to request extensive additional diligence. This can shorten the deal timeline by weeks, reduce legal and accounting expenses, and avoid the fatigue that often leads to valuation concessions late in the process.

It also helps avoid disruptive renegotiations. Without a seller-led QoE, buyers often uncover earnings “adjustments” late in diligence and attempt to re-trade the deal. In contrast, proactive sellers can say: “That’s already been addressed—see page 14 of the QoE report.” That confidence can make or break a deal.

Identifying and Mitigating Risks Early

A QoE analysis can also serve as a reality check. In some cases, the process uncovers internal weaknessessuch as revenue concentration, erratic collections, or poorly documented accruals that may require cleanup before going to market. Identifying these risks early gives sellers time to correct course, avoiding costly surprises under the pressure of a live transaction.

For example, if revenue is heavily concentrated in one customer, or if the books contain inconsistent application of revenue recognition policies, the seller can address these issues proactively by diversifying clients, restructuring contracts, or improving reporting systems. Doing so prior to sale can prevent these risks from becoming a justification for discounts or earnouts.

When to Commission a Sell-Side QoE

The timing of a preemptive QoE analysis is critical. It should occur before preparing a confidential information memorandum (CIM) or engaging with potential acquirers. A quality report typically takes 4 to 6 weeks, depending on complexity and data availability. Rushing this step compromises its effectiveness. Sellers who allow adequate runway are best positioned to go to market with a bulletproof financial story.

In M&A, perception drives valuation. Unadjusted or messy financials, unexplained margin shifts, and unresolved accounting questions often lead buyers to introduce holdbacks, reduce purchase prices, or demand indemnities. A seller who identifies and explains non-recurring expenses, working capital anomalies, and revenue recognition policies upfront avoids getting caught off-guard later in the diligence process.

In short, a preemptive QoE analysis provides sellers with the following strategic advantages:

Valuation Defense: By adjusting earnings in advance, sellers lock in higher deal value.

Buyer Readiness: A credible report builds confidence and shortens the buyer’s diligence runway.

Negotiation Strength: Sellers are prepared to respond to financial scrutiny with data, not guesswork.

Risk Containment: Identifying and resolving issues internally prevents public exposure during buyer diligence.

Market Differentiation: In competitive auctions, a clean and credible financial presentation helps a seller rise above the noise.

In competitive processes, particularly with sophisticated strategic or private equity buyers, showing up prepared with a defensible, third-party-validated earnings profile often distinguishes top-tier sellers from the rest. It doesn't just safeguard value, it maximizes it.

Conclusion: The Real Value of Quality of Earnings Analyses

Quality of Earnings analyses are no longer a luxury, they are a necessity in modern M&A. Whether buy-side or sell-side, stakeholders cannot rely on GAAP metrics alone. The most telling truths about a business’s financial health lie beneath the surface of the income statement.

A well-executed QoE analysis translates into real transactional value:

• For buyers, it derisks acquisition targets and sharpens negotiation leverage.

• For sellers, it enhances credibility and supports premium pricing.

• For investors and lenders, it validates return on investment assumptions and reduces default risk.

In short, a Quality of Earnings analysis is the due diligence tool that bridges accounting optics and operational substance, ensuring that every dollar of EBITDA is worth what it claims.

Thomas Pastore, ASA, CFA, CMA, MBA

CEO & Co-Founder of Sanli Pastore & Hill, Inc.

Mr. Pastore is CEO and Co-Founder of Sanli Pastore & Hill, Inc. He has been involved in financial consulting for over 35 years, specializing in M&As (quality of earnings, fairness opinions, projections, scenarios and stress testing), litigation consulting, intellectual property and intangible asset valuations. Mr. Pastore has served as an expert witness in federal and state courts for business litigation cases in California, Texas, Arizona, Wisconsin, Nebraska, North Dakota, and New York. He has testified in 70 trials and over 200 depositions.  

Company Overview

Sanli Pastore & Hill, Inc. (SP&H) is a firm specializing in business, brand and IP valuations, fairness and solvency opinions, quality of earnings analyses, transaction advisory services, and expert testimony and litigation opinions, forensic accounting, finance and economics, with offices in Los Angeles, Sacramento, San Diego, Chicago, Lagos, Brussels, and Paris. SP&H’s principals and senior professionals have over 200 years’ combined experience utilizing their intuition and perspective to create confidence in the results. Our partners have been named as expert witnesses in over 1,200 court proceedings and have provided over 4,000 financial opinions and testimony for shareholder disputes, marital dissolution, intellectual property litigation, mergers and acquisitions, fairness and solvency situations and other advisory services. Each year, SP&H works on over 150 matters, which include forensic accounting and litigation support matters, valuations of business brands, patents and intellectual property for businesses ranging from start-ups to Fortune 500 companies, Forbes 400 members, U.S. government agencies, and foreign governments. The industries we cover include technology, entertainment and media, medical and life sciences, consumer products, manufacturing, telecommunications, software, energy, defense and service. The firm has unequaled research and analytical capabilities, as well as the dedication, creativity and excellence of its staff, which ensure superior quality products and results.

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