QUALITY OF EARNINGS: CONTROL YOUR SALE STORY

The Quality of Earnings Report: Why Every Canadian Business Owner Planning to Sell Should Get One Before Buyers Do

If you're planning to sell your Canadian business with revenues between $5 million and $50 million, there's one critical document you need to understand: the Quality of Earnings (QoE) report. This comprehensive financial analysis has become a standard requirement in virtually every middle-market M&A transaction—and understanding it before you enter the sale process can be the difference between maximizing your exit value and leaving money on the table.

What Is a Quality of Earnings Report?

A Quality of Earnings report is a formal third-party analysis that evaluates the true economic earnings of a company by adjusting the reported earnings for various non-recurring, unusual, or one-time items that may distort the financial performance of the business. (Source: The Bonadio Group)

Unlike an audit, which focuses on whether your financial statements comply with Generally Accepted Accounting Principles (GAAP), a QoE analyzes the true economic earnings of a business by normalizing financial results and removing non-recurring or unusual items that might distort performance. (Source: BPM)

Three key areas are analyzed in a quality of earnings analysis: adjusted EBITDA, proof of cash, and working capital. (Source: Warren Averett)

Why QoE Reports Matter: The EBITDA Factor

In M&A transactions, a business is often valued based on a multiple of its EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), so being able to determine the true earnings of the business is extremely important. (Source: The Bonadio Group)

Here's the critical math: If your business reports $10 million in EBITDA and receives a 6x multiple, your enterprise value is $60 million. However, if a QoE analysis reveals $2 million in non-recurring items, your adjusted EBITDA becomes $8 million, resulting in a $48 million valuation—a $12 million difference. (Source: DueDilio)

Why Buyers Commission Buy-Side QoE Reports Post-LOI

A quick polling of M&A bankers suggests that a QoE has been part of every buyer's due diligence process over the last three years, including large strategic buyers with expansive accounting and finance departments. (Source: EdgePoint)

Buyers commission QoE reports for several critical reasons:

1. Validation of Financial Performance

A QoE report cuts through the clutter to reveal the core earnings that are truly sustainable, allowing buyers to assess the real value of the business and make decisions based on accurate, reliable data. (Source: CFO Hub)

2. Risk Identification

The report provides insights into a company's past and future earnings potential, identifying any risks that may affect the target company's financial performance. (Source: Windes)

3. Lender Requirements

A QoE report is often required by lenders or other stakeholders involved in the M&A transaction. (Source: Weaver)

4. Negotiating Leverage

The buyer's QoE findings directly influence final price negotiations. In most middle-market M&A transactions, transaction value is generally determined based on a multiple of EBITDA, and any changes to EBITDA resulting from the QoE can often lead to significant negative adjustments to the purchase price. (Source: The Bonadio Group)

The Strategic Advantage: Commissioning Your Own Sell-Side QoE Report

Many investment bankers advise sellers to hire a QoE specialist to conduct a QoE analysis and prepare a report. In fact, this is becoming standard, and for good reason. (Source: Morgan & Westfield)

Here's why smart sellers get ahead of the process:

Benefit #1: Identify and Address Red Flags Before Buyers Do

One of the greatest benefits of conducting a QoE in advance is the ability to identify and address potential red flags early. If the report reveals issues such as inconsistent financial reporting, under-accrued liabilities, or significant customer churn, the seller has the opportunity to either fix those problems or prepare a thoughtful, data-backed explanation. (Source: DAK Group)

Benefit #2: Control the Narrative

Financial due diligence will give a buyer or seller a view of the company's adjusted EBITDA. If initiated by a seller before going to market, a QoE will allow the seller and its advisors to identify and potentially address or reframe potential issues before they are identified by a potential buyer. (Source: The Bonadio Group)

Benefit #3: Accelerate the Transaction Timeline

The cost of a QoE depends on the scope of the assignment, but the expense is almost always offset in savings gained by reducing the closing period (estimated 1-2 months). Furthermore, a proactive QoE provides greater likelihood of a successful closing. (Source: EdgePoint)

Benefit #4: Maximize Valuation

A sell-side QoE report often results in a higher sales price. Because M&A transactions are valued as a multiple of earnings, the higher the earnings, the higher the value. If issues can be identified and remedied before going to market, this will lead to higher-quality earnings. (Source: Morgan & Westfield)

Benefit #5: Build Buyer Confidence

Without a sell-side Quality of Earnings report, you put yourself at an immediate negotiating disadvantage. If buyers find inconsistencies, sellers will be forced to explain or justify line items that sell-side QoE could have identified and resolved in advance. (Source: Embarc Advisors)

What Buyers Are Looking For in a QoE Report

During a QoE, the QoE provider obtains and analyzes account-level detail of the company's historical income statements and balance sheets to identify any potential adjustments to the company's reported earnings, typically evaluating monthly financial data over the most recent three fiscal years and the trailing-twelve-months period. (Source: The Bonadio Group)

Here's what buyers scrutinize:

Revenue Quality and Sustainability

Revenue recognition practices can be a source of confusion or concern for acquirers. A QoE will assess whether revenue is being recognized in accordance with standard accounting principles and whether the timing of recognition is consistent and supportable. (Source: DAK Group)

Customer and Vendor Concentrations

A business that relies too heavily on a small number of customers or suppliers is at greater risk. If one of these key relationships deteriorates, the company's revenue or supply chain could be significantly disrupted. (Source: Mountain Peak Advisory)

EBITDA Adjustments and Add-Backs

The report should examine and verify any adjustments made to arrive at adjusted EBITDA. Source documents should be examined to verify the authenticity and reasonableness of adjustments that were made when calculating EBITDA. (Source: Morgan & Westfield)

Cash Flow Verification (Proof of Cash)

The proof of cash verification gives potential buyers confidence that the reported earnings are supported by actual cash transactions and provides buyers with valuable insights into the company's cash cycles and overall financial position. (Source: Warren Averett)

Common Red Flags That Derail Deals

Understanding what raises concerns during a QoE analysis can help you address issues proactively:

Revenue Recognition Issues

Revenue should be recorded in line with accounting standards. Red flags include aggressive revenue recognition policies, premature recording of sales, and inconsistencies between revenue and cash collections. (Source: Mountain Peak Advisory)

Inconsistent Gross Margins

A significant variation in gross margins without a clear explanation is a red flag. Consistent margins indicate a stable business model, whereas unexpected changes may suggest issues such as cost mismanagement, changing sales mix, or inaccurate financial reporting. (Source: Mountain Peak Advisory)

Excessive EBITDA Adjustments

EBITDA adjustments are normal, but excessive or questionable adjustments can be a cause for concern. Common problematic adjustments include unrealistic add-backs for discretionary expenses, overly optimistic projections of future synergies, or exclusion of legitimate operational costs. (Source: Mountain Peak Advisory)

Recurring "One-Time" Expenses

While not all one-time expenses are problematic, a pattern of frequent one-offs could indicate that these costs are more recurrent than the business presents. If these expenses are omitted from normalized earnings calculations, it can mislead buyers. (Source: Redpath and Company)

Working Capital Irregularities

Volatility in working capital fluctuations may indicate operational inefficiencies, seasonal patterns, or poor cash flow management. Unusually high accounts receivable might suggest overly aggressive revenue recognition practices, while excessive or obsolete inventory may artificially inflate current assets. (Source: CFA Institute)

Cash vs. Accrual Accounting Inconsistencies

One middle-market M&A deal that seemed solid nearly fell apart when the buyer's QoE uncovered a messy mix of cash and accrual accounting, overstated assets, and missing paperwork, forcing the seller to defend the original valuation with shaky numbers. (Source: Embarc Advisors)

How QoE Reports Impact the Deal

The findings in a QoE report directly affect three critical aspects of your transaction:

1. Purchase Price Adjustments

Because a quality of earnings analysis is primarily focused on EBITDA, every adjustment can have a potential impact on purchase price. Most often in the middle market, enterprise value is set using a multiple of EBITDA. (Source: Warren Averett)

2. Deal Structure and Terms

Findings from a Quality of Earnings report can lead to purchase price adjustments, as buyers may seek to reduce the price if they identify hidden risks or inflated earnings. (Source: BradyWare)

3. Transaction Momentum

A Q of E can slow down the closing process considerably, especially if the seller is not prepared to handle the volume of requests. Slowdowns are never good for sellers. Momentum is key to getting to a successful closing. (Source: EdgePoint)

Understanding Working Capital Analysis in QoE Reports

Working capital analysis is a critical—and often misunderstood—component of every QoE report that can significantly impact your final proceeds.

What Is the Working Capital Target?

In middle-market deals, buyers almost always structure transactions to be cash-free, debt-free, meaning that the seller will walk away with any cash and be responsible for any debt on the balance sheet at closing. A working capital target is normally established prior to closing to define the amount of working capital (current assets minus current liabilities) that the seller needs to deliver to the buyer at closing. (Source: The Bonadio Group)

How Is the Target Calculated?

The working capital analysis supports both the buy side and sell side in setting a level of adequate working capital to operate the business, as defined by the signed letter of intent and represented as an average or percentage of revenue looked at in three, six or twelve-month periods, which is expected to be left in the business at close. (Source: Warren Averett)

Why Working Capital Matters

Negative net working capital can raise liquidity and financial management concerns for a company in a transaction. In middle-market deals, buyers often structure transactions to take on the responsibility of providing additional working capital beyond the closing date to address any negative net working capital situation. (Source: Warren Averett)

Common Working Capital Issues

One area for disagreement and even litigation after a transaction closes is a dispute over net working capital. The sell-side QoE team can work with the parties' attorneys to review the purchase agreement and make sure it addresses any eventualities that could arise related to net working capital calculations. (Source: Morgan & Westfield)

Analyzing net working capital often uncovers underlying issues such as customer concentration risks, supplier payment delays, or inventory turnover trends. (Source: CFA Institute)

How to Prepare Your Organization for a Buyer's QoE

Preparation is everything. Here's how to position your business for success:

For the Seller/Owner

Sellers should organize all necessary financial records, including historical statements, tax returns, bank statements, and loan agreements. Share operational details about key customers, suppliers, and contracts, and address any irregularities upfront to show transparency and reduce the chances of delays. (Source: Eton Venture Services)

Key Documents to Prepare:

Documents typically required for a QoE assessment include financial statements (income statement, balance sheet, cash flow statement), general ledger, tax returns, management accounts, sales records, expense reports, and any relevant contracts or agreements. (Source: VCFO)

For the Management Team

After all initial requests for information are met, your advisory team will request management meetings to ask questions and dig into the financials. These meetings could be anywhere from two hours to two days long, depending on the complexity of the business. (Source: Eide Bailly)

Be Prepared to Explain:

Significant one-time events that affected financial performance
Major customers and any concentration risks
Revenue recognition policies and practices
Unusual expenses or income items
Changes in gross margins or operating expenses
Working capital trends and seasonal variations

For the Accounting Function

A QoE can be a heavy lift for a business owner and his accounting team to accommodate. It stresses the importance of clean, organized, and readily available financial records. (Source: The Bonadio Group)

Critical Preparation Steps:

Ensure GAAP Compliance: The QoE due diligence process will identify accounting gaps or non-GAAP-compliant practices that may impact value or timing. (Source: HCVT)
Reconcile All Accounts: Ensure your general ledger reconciles to your financial statements with no unexplained variances
Document Add-Backs: Ensure all necessary add-backs and adjustments are properly documented. (Source: Eide Bailly)
Normalize Accounting Practices: Review your accounting policies for consistency over the historical period
Prepare Supporting Documentation: Have source documents readily available for all material transactions

Timeline Expectations

The timeframe of a quality of earnings analysis can vary depending on the complexity and availability of data. The majority of middle market analyses typically take three to four weeks. (Source: Warren Averett)

Navigating the QoE Process: A Roadmap for Sellers

Phase 1: Pre-Market Preparation (6-12 Months Before Sale)

The process for a QoE report begins when you are considering selling your company, typically within six to 12 months after you decide to sell. (Source: Eide Bailly)

Commission your own sell-side QoE report
Address any identified issues
Implement improvements to financial reporting systems
Document all add-backs and adjustments

Phase 2: Marketing Phase

Provide your sell-side QoE to qualified buyers
Build confidence in your financial statements
Reduce the due diligence burden on your team

Phase 3: Post-LOI Due Diligence

Most buyers won't engage their legal counsel to draft closing documents until the QoE report is complete because of the risk of uncovering something important that may jeopardize the deal. (Source: Morgan & Westfield)

Respond promptly to buyer's QoE team requests
Leverage your sell-side QoE team as advocates
Address questions transparently and thoroughly

Phase 4: Working Capital True-Up

Finalize working capital target based on QoE findings
Prepare for post-closing working capital adjustment
Ensure smooth handover to new owners

Key Takeaways for Canadian Business Owners

QoE Reports Are Non-Negotiable: Regardless of when a QoE is performed, a potential buyer of a middle-market business will almost always require a QoE. (Source: The Bonadio Group)
Be Proactive, Not Reactive: Getting your own sell-side QoE before going to market gives you control over the narrative and maximizes your negotiating position.
Preparation Pays: Business owners should be ready to accommodate a QoE to ensure that there are no material adjustments to asserted EBITDA (which may cause buyers to renegotiate the terms of the deal), and the QoE does not delay the overall transaction timeline. (Source: The Bonadio Group)
Working Capital Is Critical: Understanding and preparing for working capital analysis can prevent post-closing disputes and protect your final proceeds.
EBITDA Quality Matters More Than Quantity: What we're seeing in the market is that sophisticated investors are diving deep into QoE findings, and these engagements consistently uncover insights that radically change how a business is valued. (Source: BPM)
Time Kills Deals: The longer the buyer's due diligence process lasts, the more opportunity there is for the deal to fall apart. No deal is finished until the purchase agreement is signed, and every day in between is a chance for the deal to fall through. (Source: Morgan & Westfield)
Choose the Right QoE Provider: Private equity firms typically like to see well-known regional firms prepare QoE reports for firms above $10 million to $25 million in revenue. (Source: Morgan & Westfield)

Conclusion

A Quality of Earnings report is not just another checkbox in the M&A process, it's the financial foundation upon which your entire transaction will be built. For Canadian business owners in the $5-50 million revenue range, understanding QoE reports and proactively commissioning your own sell-side analysis can mean the difference between a smooth, value-maximizing exit and a prolonged, contentious process that erodes both your valuation and your confidence.

The businesses that exit successfully are those that approach the sale process with transparency, preparation, and professional guidance. By understanding what buyers are looking for, addressing potential red flags before they become deal-breakers, and presenting a clear, defensible picture of your earnings quality, you position yourself for the best possible outcome.

Don't wait for a buyer's QoE to reveal issues you could have addressed months earlier. Take control of your narrative, protect your valuation, and give yourself the best chance for a successful exit by making a sell-side Quality of Earnings report part of your sale preparation strategy.

This article is for informational purposes only and should not be considered financial, legal, or accounting advice. Business owners should consult with qualified M&A advisors, CPAs, and legal counsel when planning a business sale.