Quality of earnings (QofE)

Shayne Fitz-Coy’s definition

A quality of earnings report is an outside firm testing whether the books can be trusted, and lenders increasingly will not lend without one. For smaller deals that is often a mid-market firm such as RSM or BDO rather than one of the Big Four.

Also called QoE, QofE, Quality of earnings

Quality of earnings at Hanil Widget Works

Fictional teaching case. Hanil Widget Works is an invented company.

Hanil reports EBITDA of 5.83m, built up from net income:

The arithmetic is fine. The review starts with what the arithmetic doesn’t tell you.

First finding: depreciation. A widget manufacturer with 0.02m of depreciation is a question, not a number. The machines may be fully written off and overdue for replacement. They may be leased, with the cost sitting somewhere else. Either way, the buyer is looking at a capital bill the EBITDA doesn’t show.

Second finding: an add-back. The seller proposes adding back 0.5m for temporary staff, calling it a one-time cost. The review finds 0.3m of that work will continue at the same annual cost. Only 0.2m holds up.

That 0.3m add-back was worth 2.4m in price.

Third finding: cash. Receivables rose 1.0m because customers are paying more slowly. Earnings don’t change, but less of them reach the bank. The buyer will need more working capital at close, and that belongs in the working-capital peg.

QofE versus an audit

An audit says last year’s financial statements were fairly presented under the accounting rules. A QofE says what earnings a buyer can count on going forward. A company can pass its audit and still fail its QofE.

SBA policy scope

Effective October 1, 2026, SBA SOP 50 10 8.1, Appendix 15 requires an independent QofE report, including a proof of cash, for 7(a) Initial Acquisition and Business Expansion transactions with a business purchase price of $3 million or more. Measure the threshold before buyer equity and seller financing, and exclude real estate.

The report is prepared for the lender’s benefit, not by or for the buyer or seller. Owner Buyout, ESOP and Cooperative transactions are exempt.

The part that bites: the lender must use the earnings from the QofE in the debt service coverage ratio (DSCR) determination. The QofE number, not the seller’s, sets how much the buyer can borrow. At Hanil, that means 6.03m, not 6.33m.

Source: SBA SOP 50 10 8.1, Appendix 15

Before you use it in a bid

Tie every accepted adjustment to evidence, and read the scope section for what the firm didn’t test. A clean QofE gives you earnings you can defend. You still have to decide what they’re worth and how to finance them.