10 Red Flags to Look for in a Quality of Earnings Report

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 When purchasing a business, the hardest part is knowing what’s real and what isn’t.

A set of financials can look clean on the surface, but that doesn’t mean the underlying business is. This is where a quality of earnings (QoE) analysis comes in. It helps surface issues that can impact both valuation and how the business actually performs after closing.

Below are ten common red flags every buyer should look for before finalizing a deal.

Revenue can look strong at first glance, but the real question is whether it’s sustainable.

Some businesses include non-recurring income or recognize revenue earlier than they should. This can make the top line look better than it actually is.

If revenue doesn’t repeat, it shouldn’t be valued the same way.

One-time events can distort profitability.

Legal settlements, insurance payouts, or unusual gains might boost earnings in a given year. On the flip side, one-time expenses can make performance look worse than it really is.

Adjusting for these items helps isolate what the business earns on a normal basis.

If a large portion of revenue comes from one or two customers, that’s a risk.

If that relationship changes after closing, the impact can be immediate.

For example, a business generating $5 million in revenue might look stable until you realize one customer accounts for $2 million of it.

Expenses should generally move in line with the business.

If payroll, marketing, or other costs spike without a clear reason, it can point to inefficiencies or hidden issues.

Inconsistent expense patterns are often worth a closer look.

Some businesses push the limits on accounting decisions.

This might include extending depreciation schedules or capitalizing costs that should be expensed. These choices can make profitability look stronger than it really is.

A QoE helps normalize these decisions so you’re looking at a more realistic number.

Profit margins tell you how efficiently a business operates.

If margins are declining or inconsistent, it could signal rising costs, pricing pressure, or operational issues.

Looking at trends over time gives a better sense of whether the business is stable or drifting.

Working capital keeps the business running day to day.

If it’s misstated, you could run into issues immediately after closing.

Seasonality, timing differences, or unusual adjustments can all distort what the business actually needs to operate.

Inventory can quietly create problems.

Excess or obsolete inventory ties up cash and inflates asset values. Low turnover can signal demand issues or poor planning.

If inventory isn’t clean, it can become your problem after the deal closes.

Just like customers, relying too heavily on a few suppliers creates risk.

If a key vendor changes terms or stops supplying, operations can be disrupted quickly.

Diversification here matters more than most buyers expect.

Tax issues tend to show up at the worst time.

Unpaid sales tax, aggressive positions, or incorrectly claimed deductions can all lead to unexpected costs.

These don’t always show up clearly in financial statements, which is why they’re worth digging into.

Every deal has issues.

The goal isn’t to find a perfect business. It’s to understand what you’re actually buying.

A quality of earnings report helps bring these risks to the surface so you can factor them into valuation and deal structure.

At QOE Prep, we focus on uncovering the details that matter so you can move forward with a clearer picture of the business behind the numbers.