One of the most important metrics not talked about enough in mid-market business sales is quality of earnings. Whether you are looking to be more profitable, looking to scale, or looking to sell — quality of earnings determines how defensible your profit number actually is. Not your revenue number. The defensibility of your profits. That distinction is worth millions of dollars at the closing table. Learn the full framework in Exit Ratio 360™ and at Exit Ratio 360™ — the 360-point evaluation system.
What is a quality of earnings report?
A quality of earnings report is not a cursory look at your books the way a standard accountant review would be. Think of Excell Eddy and Excell Edwina — because they excel at what they do — going column by column through every line of your business. What is the most profitable line? What is the least profitable? Is the profit number you are presenting actually defensible? Most business owners look at year end and say they had a million dollars in sales and $100,000 in profit. A quality of earnings report breaks down each individual line to determine whether that profit is real, repeatable, and defensible — or padded with items that do not represent the true earning power of the business under new ownership.
What is a quality of earnings report?
A quality of earnings report is a column-by-column analysis of a business’s financials examining every line to determine whether the profit number is truly defensible. It identifies the most and least profitable lines, examines add-backs, and determines the true adjusted EBITDA a buyer would accept.
Why do buyers use quality of earnings against sellers?
When you go to sell your business the buyer brings their own analyst team. Their job is to find every item in your financials that should not be added back — one-time expenses, owner perks run through the business, trips, masterminds, personal expenses that cleared the IRS legally but do not represent the true profitability of the organization. Say you have a $20 million company with $4 million in profit — 20 percent margin. The buyer’s team goes through your add-backs and finds $500,000 in items that are legal for accounting but do not prove profitability. Your adjusted EBITDA drops to $3.5 million. At a six times multiple that adjustment costs you $1.8 million at close.
Why do buyers use quality of earnings against sellers?
Buyers bring their own QoE team to find every add-back that should not be included. On a $20M company with $4M in profit, finding $500K in questionable add-backs reduces adjusted EBITDA to $3.5M. At a six times multiple that costs the seller $1.8M at close.
What is add-back stuffing and why is it dangerous?
Add-back stuffing is when a seller throws everything possible into their add-backs to inflate the adjusted EBITDA number going into a sale. The problem is that it builds doubt. When a buyer’s analyst sees a bloated add-back schedule with questionable items the reaction is not just to remove those specific items — it is to ask what else is wrong with these numbers. That doubt spreads through the entire diligence process. Clean add-backs with a defensible documented rationale for each item are worth more than a stuffed schedule that triggers skepticism across the board.
What is add-back stuffing and why is it dangerous?
Add-back stuffing is inflating the add-back schedule with everything possible to increase adjusted EBITDA. It builds doubt — when a buyer’s analyst sees a bloated schedule they question every other number in the financials, spreading skepticism through the entire diligence process.
What is the difference between EBITDA and adjusted EBITDA?
EBITDA is earnings before interest, tax, depreciation, and amortization — a standardized measure of operating profitability. Adjusted EBITDA takes EBITDA and adds back legitimate one-time expenses and owner-specific costs that a new buyer would not incur. The gap between your reported EBITDA and your adjusted EBITDA is the battleground where multiples are won and lost. A $500,000 difference in adjusted EBITDA at a six times multiple is $3 million at close. At an eight times multiple it is $4 million.
What is the difference between EBITDA and adjusted EBITDA?
EBITDA is earnings before interest, tax, depreciation, and amortization. Adjusted EBITDA adds back legitimate one-time expenses and owner-specific costs a new buyer would not incur. A $500K difference in adjusted EBITDA at a six times multiple is $3M at close.
How does a quality of earnings report help you get the maximum multiple?
When you have quality of earnings reports signed by a CPA firm covering three consecutive years and presented as part of your Titan Thesis, you are showing the buyer that a qualified third party has already reviewed and validated your financials. That report puts the CPA firm on the line. It pre-empts the buyer’s diligence process by answering the hardest questions before they are asked. If your industry trades at an eight times multiple and you are asking for twelve — three years of clean CPA-reviewed quality of earnings is the proof that supports the premium.
How does a quality of earnings report help you get the maximum multiple?
Three years of clean CPA-reviewed QoE reports presented as part of your Titan Thesis pre-empts the buyer’s diligence process. When your industry trades at eight times and you are asking for twelve, that documentation is the proof that supports the premium and becomes your defensive moat.
When should you start building quality of earnings documentation?
The 5-4-3-2 Exit Planning Framework — five years, four years, three years, two years before your target exit date. Quality of earnings documentation belongs in years four through two. Three consecutive years of clean CPA-reviewed earnings is the gold standard. You cannot build that in six months before a sale.
When should you start building quality of earnings documentation?
The 5-4-3-2 window — five years, four years, three years, two years before your target exit date. Three consecutive years of clean CPA-reviewed earnings is the gold standard. You cannot build that in six months before a sale.
How much does a quality of earnings report cost?
From a mid-level CPA firm a quality of earnings report typically costs between $40,000 and $100,000. The right way to think about it is as an investment. If the difference between a market multiple and the maximum multiple is two to three turns on a $3.5 million EBITDA business — that is $7 million to $10.5 million in additional value at close. A $60,000 to $100,000 investment to protect and increase a seven-figure outcome is not expensive.
How much does a quality of earnings report cost?
From a mid-level CPA firm a quality of earnings report typically costs between $40,000 and $100,000. If two to three additional multiple turns on a $3.5M EBITDA business adds $7M to $10.5M in value at close, that investment pays for itself many times over.
How does quality of earnings connect to the Exit Ratio 360™?
The Exit Ratio 360™ SCORE Framework — the largest component at 100 points — evaluates financial quality and the defensibility of revenue and profit numbers. Three years of clean CPA-reviewed quality of earnings reports directly increases your SCORE Framework score and the multiple range a buyer will pay. A business that scores well on SCORE has the financial characteristics buyers pay premiums for.
How does quality of earnings connect to the Exit Ratio 360?
The Exit Ratio 360 SCORE Framework evaluates financial quality and the defensibility of revenue and profit numbers. Three years of clean CPA-reviewed quality of earnings documentation directly increases SCORE Framework scores and the multiple range a buyer will pay.
Related: Exit Ratio 360™ | Titan Thesis | 5-4-3-2 Framework | Do I Need an M&A Advisor | Exit Ratio 360™ on Amazon
About Scott Sylvan Bell
Scott Sylvan Bell is a mid-market exit strategy consultant and the creator of the Exit Ratio 360™. His book is available on Amazon.