Understanding the Difference and Why It Matters in a Transaction
In any merger or acquisition, value is driven by two fundamental considerations earnings and risk. As a result, clients are often introduced to both due diligence and a Quality of Earnings (QOE) report during a transaction and understandably confuse the two. While related, they serve very different purposes.
Understanding how they differ, and how they work together, is essential to making informed and confident transaction decisions.
What Is a Quality of Earnings Report?
A Quality of Earnings report provides independent, transaction‑focused financial analysis that explains how a business generates its results, the sustainability of those results, and the financial risks embedded in the earnings stream. Unlike a traditional audit or review engagement, a QOE is not designed for historical financial compliance. Instead, it focuses on economic reality and maintainable performance for the future.
A QOE report typically examines:
- Normalized EBITDA and earnings
- Revenue recognition practices
- Gross margin consistency and cost structure
- Nonrecurring, discretionary, or owner‑related expenses
- Customer concentration and revenue volatility
- Working capital trends
- Non‑operating income and unusual transactions
- Balance sheet analysis
The objective is to determine the level of earnings or cash flow that is maintainable going forward and therefore capable of supporting the purchase price otherwise known as the enterprise value. Because most M&A transactions are priced as a multiple of normalized earnings, a QOE plays a central role in validating sustainable performance, supporting accurate valuation, enhancing credibility with lenders and investors, and strengthening negotiation positions.
What Is Due Diligence?
Due diligence is a holistic review into all aspects of a business. It is a broad, risk‑oriented process designed to verify key facts, confirm strategic assumptions, and uncover potential deal‑breakers before closing. Due diligence is not just about the numbers. It is about validating that the entire foundation of the business is sound.
Due diligence typically covers multiple areas, including:
- Financial: Historical performance, working capital, debt, cash flows, and financial controls
- Legal: Contracts, litigation history, ownership structure, and regulatory matters
- Tax: Compliance, exposures, structure, and transaction‑related considerations
- Operational: Management depth, systems, supply chains, and IT infrastructure, HR concerns
- Commercial: Market position, customer concentration, competitive landscape, and growth risks
The objective of due diligence is to assess the overall risks and opportunities associated with an acquisition, validate the assumptions underlying the purchase decision, and confirm alignment with the buyer’s strategic and financial objectives.
How They Differ and How They Work Together
The key differences between due diligence and a QOE lies in scope and purpose.
- Due diligence is generally more comprehensive as it evaluates multiple dimensions of the business to support an acquisition decision and protect against unexpected issues post‑closing.
- Due diligence is risk-oriented and therefore can be more flexible. Depending on the knowledge and risk profile of the buyer, they may have comfort around certain aspects of the business being purchased and will therefore adapt the scope of due diligence, both financial and non-financial, to focus more on areas of concern from a perceived risk standpoint. In contrast, a Quality of Earnings report may not provide the same flexibility especially when a financial institution is involved.
- A QOE is narrower and analytical. It focuses specifically on the reliability and sustainability of earnings and financials, forming the foundation for valuation and pricing.
- The requirement for a Quality of Earnings report tends to be driven by the financial institution providing financing for the proposed transaction as they seek independent reporting on the sustainability of the earnings/cash flow that will be used to repay the financing.
In practice, a QOE is often a critical component of financial due diligence, but it does not replace the broader diligence process. Due diligence answers the question what risks exist across the business, and how should they be reflected in the deal where as a QOE answers what cash flow am I really buying.
Quality of Earnings and due diligence can be complementary, and are not necessarily interchangeable. Understanding the difference ensures the right questions are asked at the right time, leading to better pricing, smoother negotiations, and stronger transaction outcomes.
Buyer and Seller Perspectives
For sellers, a QOE can be prepared in advance of a transaction to support valuation, enhance transparency, and streamline the sale process. For buyers, it provides confidence that the earnings used to price the transaction are well‑founded. Due diligence, however, remains essential for uncovering broader legal, operational, tax, and commercial risks that could impact deal structure or post‑closing outcomes.
A Valuation‑Led Approach
When led by Chartered Business Valuators, QOE and due diligence engagements benefit from a valuation‑first perspective. CBVs understand not only how to normalize earnings, but also how each finding impacts enterprise value, transaction pricing, and risk allocation.
At SB Partners, our CBV‑led team delivers rigorous, practical QOE and due diligence analysis designed to reduce uncertainty, protect value, and support confident decision‑making throughout the transaction process.
