While a business valuation and a Quality of Earnings analysis may examine many of the same financial and operating matters, they generally do so with a different depth of review. A valuation often relies on the financial information and operating assumptions provided, making adjustments as necessary to estimate value. A QoE examines the support behind those numbers more closely by reconciling financial information, reviewing underlying documentation, analyzing trends, investigating inconsistencies, evaluating transaction-specific considerations, and clarifying significant matters with management.
Without this level of diligence, uncertainties may remain within the transaction, potentially resulting in unintended transfers of value between the buyer and seller. Fundamentally, a QoE is designed to address three key areas that directly influence the valuation of a company:
How well does reported EBITDA reflect sustainable operating earnings?
Evaluates normalization adjustments such as owner and management compensation, related-party or market rent, repairs and maintenance, discretionary expenses, and other nonrecurring or non-operating items. It also analyzes historical margins, revenue and expense trends, discontinued or declining business lines, and other changes in the business that may affect whether reported EBITDA is representative of ongoing operations.
What assets and obligations should be considered in the transaction?
Assesses working capital and cash requirements, identifies significant operating assets necessary to support ongoing earnings, distinguishes operating assets from non-operating or excess assets, and evaluates debt and other financing obligations relevant to the transaction. The analysis also considers the role of real estate, including available indications of value, its importance to business operations, whether the operating business can function independently of the property, and the financial implications of retaining, transferring, leasing, or separating the real estate under the contemplated transaction structure.
What financial and operating risks could affect the transaction?
Evaluates factors that may affect the sustainability, reliability, or transferability of the business, including customer and vendor concentration, dependence on key employees or owners, changes in revenue streams or margins, accounting and reporting limitations, unusual or nonrecurring items, unresolved balance-sheet matters, financing obligations, operational dependencies, and other transaction-specific issues that could affect future performance or deal terms.
Quality of Earnings Best Practices
QoE analyses are commonly used by private equity firms, institutional buyers, lenders, and other sophisticated acquirers before completing a transaction. Beginning October 1, 2026, the SBA also requires an independent QoE for certain SBA-financed change-of-ownership transactions of $3 million or more, further reflecting the growing role of QoE analysis in lower-middle-market transactions.
How Does a QoE Differ from an Audit or Review?
Although a Quality of Earnings (QoE) analysis may incorporate procedures similar to an audit, such as reconciling financial information, substantively testing selected transactions and account balances, and investigating accounting inconsistencies, it does not constitute a comprehensive audit. An audit involves broader testing across significant financial statement accounts to obtain reasonable assurance that the financial statements are free from material misstatement. Consequently, an audit provides a greater opportunity to identify errors or irregularities that may fall outside the scope of a QoE.
A QoE is not an assurance engagement and does not provide assurance that financial statements are free from material misstatement or fraud. Instead, it incorporates targeted testing and analytical procedures focused on accounts and transactions affecting earnings, working capital, fixed assets, and profitability. While not exhaustive, these procedures explore the nature and composition of these accounts, identify significant adjustments or inconsistencies, and provide information used to assess the company's sustainable, run-rate earnings and operating characteristics, which are fundamental to its valuation.
Many firms seeking a QoE have already obtained audited or reviewed financial statements. In the event we perform a QoE on financial statements that have not been audited or reviewed, and accounting irregularities, inconsistencies, or concerns regarding the reliability of financial information arise during our analysis, we may recommend additional verification procedures. BRACCV does not perform financial statement audits or reviews.
