Why Private Equity and Strategic Buyers Rely on a Quality of Earnings Study Before Trusting the Numbers, Dr. Thomas J. Powell

In acquisitions, earnings are rarely what they appear to be at first glance. Financial statements can be accurate, audited, and compliant with generally accepted accounting principles, yet still fail to answer the most important deal question: how much of this company’s earnings are durable, repeatable, and convertible to cash for a new owner. A quality of earnings (QoE) study exists precisely to answer that question. In private equity and strategic acquisitions alike, QoE serves as the bridge between accounting compliance and economic reality, translating historical performance into a defensible foundation for valuation, leverage, and contract structure.¹

A QoE study does not exist to criticize accounting practices or to restate financials for their own sake. Instead, it functions as a decision framework that connects diligence evidence to enterprise value and to the mechanics governing how consideration moves at closing. Buyers do not acquire income statements; they acquire cash-generating capacity. QoE analysis focuses relentlessly on whether reported earnings reflect that capacity in a way that will persist under new ownership.²

QoE vs. Audit: Why Compliance Is Not Economic Truth

One of the most common misunderstandings in transactions is the assumption that audited financial statements eliminate the need for a quality of earnings analysis. Audits and QoE studies serve fundamentally different purposes. Audits are designed to provide reasonable assurance that financial statements are free of material misstatement, typically emphasizing balance-sheet integrity and applying materiality thresholds appropriate for financial reporting.³

A QoE study, by contrast, evaluates earnings through the lens of valuation. In valuation, even relatively small adjustments can materially affect enterprise value once earnings multiples are applied. Audits also operate on an annual cadence and may not capture recent shifts in pricing, customer behavior, or cost structure. QoE analyses typically focus on trailing twelve-month performance, monthly trends, and normalization. Buyers and lenders price deals on current earning power, not on last year’s audited snapshot.⁴

In short, audits answer whether the numbers are reported correctly. QoE answers whether the numbers mean what the buyer thinks they mean.

Metrics and Methodology: From Reported Results to Economic Earnings

The analytical core of a QoE study is the construction of a transparent bridge from reported results to an earnings metric aligned with how the transaction will be valued. In U.S. transactions, this almost always involves EBITDA or an adjusted form thereof. Regulatory guidance makes clear that EBITDA has a specific definition and that deviations must be labeled accordingly, reinforcing the importance of precision and transparency.⁵

This distinction matters because EBITDA is not cash flow. Sustainable earnings must account for working capital requirements, maintenance capital expenditures, and cash taxes.⁶ QoE analysis therefore focuses not only on adjusted EBITDA but also on the balance-sheet dynamics that govern how earnings convert into cash. Without this bridge, valuation models rest on abstractions rather than economics.

Testing the Numbers: Proof of Cash and Revenue Integrity

Credible QoE findings require verification. Among the most important procedures is proof of cash, which reconciles reported earnings to actual cash movements through bank statements and underlying records. Proof of cash testing helps confirm that revenue is supported by collections, that expenses are complete, and that liabilities are not understated.⁷

Revenue recognition testing further anchors earnings in economic substance. Even when revenue complies with accounting standards, timing differences can inflate trailing twelve-month results in ways that will not persist. QoE teams therefore test cutoffs, billing practices, customer concentration, and gross-profit dynamics to determine whether reported growth reflects sustainable demand or merely accounting acceleration.⁸

Working Capital Analysis: The Quiet Driver of Deal Economics

Net working capital sits at the center of QoE because it determines whether earnings are usable without additional capital injections. Net working capital represents the capital required to operate the business on a normalized basis. Deviations from that level directly affect purchase price through closing adjustments. Elevated receivables, obsolete inventory, or delayed payables can inflate earnings while silently consuming cash.⁹

QoE analysis informs the setting of the net working capital target, typically based on historical averages over a six- to twelve-month period.¹⁰ This target becomes a contractual mechanism that protects the buyer from acquiring a business that requires immediate capital support. Without rigorous QoE input, working capital targets often become sources of post-closing disputes rather than tools for alignment.

Purchase Price Mechanics: How QoE Becomes Contract Language

QoE findings ultimately live in the purchase agreement. Completion accounts, which true up cash, working capital, debt, and transaction expenses after closing, rely directly on QoE definitions and normalization logic. Alternatively, locked-box structures fix equity value at signing based on a historical balance sheet, placing even greater importance on QoE accuracy at that point in time.¹¹

In both structures, QoE provides the economic vocabulary governing price adjustments, leakage protections, and post-closing certainty. When diligence teams fail to connect QoE outputs to contractual terms, valuation discipline erodes and disputes proliferate.¹²

Private Equity and Strategic Buyers: Different Objectives, Same Foundation

Private equity investors typically rely on QoE to protect leverage assumptions and ensure that debt can be serviced through recurring cash flow. Strategic buyers, while often focused on synergies and integration, rely on QoE to isolate baseline economics before attributing value to future benefits.¹³

Synergies cannot be evaluated credibly until the stand-alone economics of the target are clearly understood. QoE separates what exists today from what may exist tomorrow, allowing each buyer type to price risk appropriately.

Illustrative Examples: How QoE Changes Outcomes

One illustrative QoE finding involves EBITDA add-backs in founder-led businesses. Seller-proposed adjustments often include non-recurring expenses and excess owner compensation. Buyers must validate each adjustment with underlying documentation.¹⁴ For illustration only, a business reporting $5.0 million of EBITDA may ultimately support $5.7 million after validating add-backs and correcting understated recurring costs. At an 8.0× multiple, that difference materially alters enterprise value.

A second illustration involves revenue growth that does not translate into cash. Proof of cash testing may reveal that growth is driven by extended payment terms rather than demand, increasing working capital needs and reducing effective cash flow. Corrections affect both adjusted earnings and the working capital target, directly influencing purchase consideration.¹⁵

A third illustration concerns working capital true-ups. If a negotiated target is missed at closing, purchase consideration adjusts dollar-for-dollar, protecting the buyer from funding the seller’s liquidity gap.¹⁶ These outcomes demonstrate why QoE is not an academic exercise but a value-defining discipline.

Why QoE Remains Indispensable

A quality of earnings study does not guarantee a good deal, but the absence of one almost guarantees blind spots. QoE transforms financial statements into economic insight, aligns valuation with cash-generating capacity, and embeds discipline into deal mechanics. For private equity firms and strategic acquirers alike, it provides the analytical integrity required to move from interest to conviction.

Certainty is never free in transactions, but uncertainty is always expensive.

Endnotes

Association of International Certified Professional Accountants, Due Diligence (2024).

Porter, B., & Sproul, B., What to Know About a Quality of Earnings Report in Pre-Sale Due Diligence (Moss Adams, 2025).

Chapman, W. A., Ten Considerations in a Quality of Earnings Study (2022).

Porter & Sproul, 2025.

U.S. Securities and Exchange Commission, Non-GAAP Financial Measures: Section 103 (EBIT and EBITDA) (2010).

Chapman, 2022.

Dilawer, A., Quality of Earnings: A Critical Lens for Financial Analysts (CFA Institute, 2025).

Chapman, 2022.

Dilawer, 2025.

Jones, F. S., Jr., Net Working Capital and Purchase Price Adjustments in M&A Deals (2024).

Cooley LLP, Locking the Box in Private M&A Transactions (2022).

Deloitte Netherlands, Prepare and Execute the Deal: Due Diligence (n.d.).

Baker Tilly, Due Diligence (n.d.).

Chapman, 2022; SEC, 2010.

Dilawer, 2025.

Jones, 2024; Cooley LLP, 2022.