Quality of Earnings Reports: What Sellers Need to Know

A common misconception among mid-market business owners is that a clean audit report from a certified accountant validates the value of their company. In the world of Mergers & Acquisitions (M&A), an audit is merely the ticket to enter the stadium—the actual playbook is dictated by the Quality of Earnings (QofE) report.

While an audit confirms compliance with accounting standards (such as UK GAAP, IFRS, or local commercial codes) and ensures that the balance sheet is "true and fair" at a specific point in time, a QofE analysis looks far beyond these formalities. Its primary objective is to assess the sustainability and repeatability of cash flows. For a seller, it is crucial to understand that buyers use this tool to rewrite your EBITDA—often downwards.

The Psychology of Adjustments

A QofE report focuses primarily on North America and European mid-market standards of "Adjusted EBITDA." Buyers search for reasons why historical profits might not be a reliable indicator of future performance. We generally categorise these adjustments into three buckets:

1. Non-recurring items: This includes insurance settlements, legal costs from a one-off dispute, or exit bonuses paid to staff.
2. Non-market expenses: In owner-managed businesses, this often involves the founder’s salary, family cars on the business, or rent paid on self-owned property that sits above or below market rates.
3. Pro-forma adjustments: This is the technical heart of the report. A QofE corrects "revenue spikes" at year-end caused by aggressive invoicing without corresponding performance progress.

For the seller, this means: a high EBITDA in the previous year is worthless if the QofE report proves that 20% of it resulted from a major contract that will never recur.

Net Working Capital: The Hidden Price Correction

A significant portion of any QofE report deals with Net Working Capital (NWC). In sale purchase agreements (SPAs), an "NWC Target" (or peg) is usually established. If the actual working capital at the time of completion is lower than this target, the purchase price decreases pound-for-pound.

Buyers use QofE analysis to identify trends in inventory, accounts receivable, and accounts payable over a rolling 12-month period (LTM). If you, as a seller, drastically reduce your inventory just before the sale to generate cash, the QofE report will expose this as "unnatural" and adjust the NWC target upwards accordingly. A robust report helps depict seasonality objectively so that the seller is not penalised for the normal volatility of their business model.

Revenue Quality and Customer Concentration

The analysis goes deeper than the general ledger entries. A sophisticated QofE report analyses customer cohorts. What is the churn rate? How stable have margins been per customer over the last three years?

Special attention is paid to customer concentration. If a single client delivers more than 15-20% of the contribution margin, a buyer will apply a risk discount to the multiple or insist on an earn-out structure. The QofE report serves as a diagnostic tool here to alleviate the buyer’s fear of "lump risk"—or to expose it mercilessly. We often advise our clients to perform this analysis internally months before going to market to prepare arguments regarding the loyalty and longevity of these key accounts.

Sell-Side QofE: The Best Defence is a Good Offence

Why should a seller spend money on a report that the buyer will commission anyway? The answer lies in the control of the "narrative."

When a buyer conducts their own due diligence (Buy-Side QofE), they will use every discrepancy as a negotiation lever to lower the price—a tactic known as "price chipping." A Sell-Side QofE allows you to find the skeletons in the closet yourself and address them proactively. When you present a professional report from a reputable firm in the data room, you set the benchmark for the definition of EBITDA. It significantly accelerates the process and minimises the risk of the deal falling through in the late stages due to "surprising" findings.

Conclusion: Preparation is the Only Currency

A Quality of Earnings report is not an administrative burden; it is the central document of value determination. Those who only begin to understand how their working capital is defined or why their gross margin fluctuates during the exclusivity phase have already half-lost the negotiation battle.

For European mid-market entrepreneurs, the message is clear: do not rely solely on your gut feeling or your balance sheet total. Preparing your own QofE is an investment in price certainty. It enables you to argue with the same data precision as the investment professionals on the other side of the table.

Audit vs. Quality of Earnings Report

It's common to conflate an audit with a Quality of Earnings report, but they serve distinct purposes in M&A. This table highlights their key differences.