How to Answer “Walk me through a Quality of Earnings (QoE) analysis.” in Private Equity Interviews

I start by stating the objective: a Quality of Earnings analysis converts GAAP/IFRS results into a maintainable earnings base a buyer can underwrite for pricing and leverage. I explicitly name the metric—most often LTM adjusted EBITDA, but sometimes EBIT or gross profit if the business is capex-heavy or valued differently.

Then I set scope: monthly P&L for 24–36 months plus LTM, balance sheet and cash flow, and source data (trial balance/GL detail) to rebuild the numbers consistently. I clarify boundaries: QoE is not a statutory audit and it’s not a synergy plan; it’s a diligence view of earnings sustainability and downside risks.

I preview the workstreams I’ll cover: (1) rebuild and trend the P&L, (2) create a reported-to-adjusted bridge, (3) test revenue quality and margin drivers, (4) reconcile earnings to cash via working capital and maintenance capex, and (5) convert findings into valuation and deal protections.

Mechanically, I rebuild the P&L from the trial balance/GL, standardise account mapping, and trend results monthly to identify seasonality, step-changes, and reclassification noise (e.g., COGS vs opex). This gives a clean “reported baseline” before any adjustments.

Next, I build the bridge from reported EBITDA to adjusted EBITDA with each item categorised and supported. Typical buckets are: (a) non-recurring (one-time professional fees, discrete litigation), (b) non-operating (asset sale gains/losses), (c) timing/accounting policy (cut-off errors, capitalise vs expense), and (d) run-rate/pro forma items (full-year impact of a site opening or acquisition) where evidence exists.

For each adjustment I articulate three tests: is it truly non-recurring, is it incremental (not already embedded in the run-rate trend), and what is the proof (invoice, contract, board-approved programme, payroll files). That’s what makes the bridge defensible in the IC memo and lender diligence.

I make clear that QoE is not just an add-back exercise on expenses. I test revenue durability by analysing customer concentration, contract terms, churn/retention, pricing vs volume mix, rebates/credits/returns, and any end-of-period spikes that suggest pull-forward.

On revenue recognition, I confirm the policy and look for inconsistent application over time or aggressive cut-off. Depending on the business model, I reconcile revenue to billings and cash and tie to balance sheet accounts—deferred revenue for subscription/prepaid models, WIP/unbilled AR for project-based services, or reserves/contra-revenue for returns and rebates.

I also link revenue quality to margin sustainability: are gross margin movements driven by true economics (mix, utilisation, input costs) or by accounting/classification shifts and under-accruals. The output is a view on repeatability, not just a single adjusted EBITDA number.

Then I connect adjusted earnings to cash generation, because cash conversion drives debt capacity in Private Equity. At a high level, I walk from adjusted EBITDA to operating cash flow by considering cash taxes, working capital movements, and a normalised view of maintenance capex (separating maintenance vs growth where possible).

For working capital, I assess both level and quality: AR ageing and bad debt policy, inventory reserves and obsolescence, AP terms and any stretched payables, seasonality, and any pre-close “window dressing.” This is where findings often affect purchase agreement mechanics—especially the working capital peg and the likelihood of a true-up.

I also look for balance-sheet items that can mask earnings: under-accrued expenses, misclassified operating vs non-operating items, related-party arrangements, and non-recurring cash costs that may not be captured in the EBITDA bridge but matter for the equity cheque and post-close liquidity.

I finish by translating the analysis into decision-ready underwriting outputs. The deliverable is a defendable adjusted EBITDA (or EBIT) base with a clear schedule of adjustments, supporting evidence, and a view on which items are “hard” versus “grey.”

In the model and investment memo, I show how changes in the earnings base impact valuation (e.g., EBITDA multiple math), leverage ratios, and covenant headroom—then sensitivity-test the grey items rather than forcing a single number. A common approach is to apply partial credit or haircut to contested add-backs and present a range.

Finally, I connect risks to deal terms: tighter definitions in the SPA, a working capital peg aligned to steady state, potential holdbacks or earn-outs where revenue durability is uncertain, and alignment with lender EBITDA add-back baskets. That demonstrates you can turn financial due diligence into pricing and risk protection, not just accounting adjustments.