What Quality of Earnings Actually Finds in a Medical Group

When a physician group starts talking to private equity, a hospital system, or another practice, the first serious document on the table is rarely the tax return. It is a quality of earnings report.

Quality of earnings (QoE) is the buyer’s way of answering one question: how much of this EBITDA would still be there if we owned the practice tomorrow? Owners who wait until a letter of intent to find out usually give up price, structure, or both. The work that survives a QoE is the same work a healthcare fractional CFO should be doing well before a process starts.

This article walks through what QoE actually tests in physician groups and ambulatory surgery centers—not textbook definitions, but the findings that change deal value. For context on deal dynamics, see Private Equity in Physician Groups.

QoE is not an audit

An audit asks whether the financial statements were prepared in accordance with GAAP. A QoE asks whether the earnings a seller is marketing are sustainable, transferable, and free of owner-specific noise.

In a medical group that usually means three layers:

• Reported EBITDA versus normalized EBITDA.
• Cash earnings versus accrual earnings, especially around A/R, credit balances, and underpayments.
• Earnings that belong to the practice versus earnings that belong to a particular physician, contract, or coding pattern.

Those distinctions live in financial reporting and in how the chart of accounts is built. If the books mix owner perks, real estate, and clinical operations in one P&L, the QoE firm will rebuild the statements before they ever debate multiple.

Finding 1: Owner compensation that is not market

The most common normalization in physician groups is provider pay. If owner-physicians take distributions instead of W-2 compensation, reported EBITDA is inflated. If they pay themselves well above a locum or employed benchmark for the specialty and productivity, EBITDA is understated.

Buyers do not care which way the distortion runs. They will restate compensation to a market package for the same RVUs or collections, then recast EBITDA. Groups that have never benchmarked compensation by specialty and productivity walk into that conversation unprepared.

Tip: Maintain a provider-level P&L: collections, wRVUs, compensation, midlevel support, and allocated overhead. That schedule is the first exhibit a QoE team will request.

Finding 2: Add-backs that will not survive

Sellers often present a long list of “one-time” items: legal fees, a failed EMR conversion, a recruiting bonus, PPP or relief funds from prior years, and personal expenses run through the practice. Some of those are legitimate. Many are not.

QoE teams test whether the cost is truly non-recurring, whether a buyer would still incur it, and whether it was already in the run-rate. Recurring “one-time” IT projects, ongoing legal matters, and under-maintained facilities get put back into earnings.

The clean version of this work is what M&A support should produce 12–18 months before a process: a documented bridge from reported net income to adjusted EBITDA, with each add-back supported by invoices and a one-sentence rationale.

Finding 3: Revenue that is not collectible

Gross charges are not earnings. Even net production is not earnings if denials, timely-filing write-offs, and underpayments are poorly tracked.

Typical QoE adjustments in revenue cycle include:

• Overstated A/R that should have been reserved or written off.
• Credit balances that are liabilities, not an offset to A/R.
• Payer mix shifts that make last year’s collection rate a poor proxy for next year’s.
• Coding or modifier patterns that a compliance review would not defend.

These are the same leaks described in 7 Hidden Cash Leaks in Healthcare. A buyer will haircut earnings for them whether or not the seller agrees. Cleaning A/R aging, denial root causes, and net collection rate before the QoE starts is cheaper than arguing about them in a data room.

Finding 4: Earnings concentrated in a few providers or sites

A group can show healthy EBITDA and still fail the “transferable” test. If 40% of collections sit with two partners who have not signed a post-close employment agreement, the buyer will treat that earnings stream as at-risk. The same is true of a single ASC block-time arrangement or a hospital stipend that expires at change of control.

QoE will quantify provider concentration, site concentration, and contract concentration. The financial fix is not cosmetic. It is recruitment, associate-to-partner paths, and contracts that survive a sale. Those items sit outside the general ledger, which is why a QoE is never only an accounting exercise.

Finding 5: Related-party real estate and management fees

Many groups lease from an entity the physicians own. Rent may be below market (inflating practice EBITDA) or above market (deflating it and parking value in the real-estate LLC). Management fees to a related MSO create the same problem.

Buyers recast occupancy to market rent and decide whether they want the building at all. That is why lease-versus-buy and related-party rent should be documented before a process—not discovered in diligence. See also our real estate financial management work.

Tip: Keep a one-page related-party schedule: landlord entity, rent, CAM, personal guarantees, and a third-party rent comp. QoE will build this if you do not.

Finding 6: Working capital that is not “normal”

Purchase agreements peg closing working capital to a “normalized” level. In medical groups that peg is usually A/R plus supplies minus A/P, accrued payroll, and credit balances.

If A/R is bloated or payroll accruals are missing, the seller funds the gap at close. This is a cash issue, not an EBITDA issue, and it is why cash flow and treasury management belongs in deal prep. A rolling view of DSO, denial dollars, and accrued PTO prevents a last-week surprise on the working-capital true-up.

Finding 7: Accounting policies that overstate the current year

Cutoff is a quiet QoE topic. Revenue recorded when billed rather than when earned, expenses pushed into the next month, and inventory of high-cost implants that was never counted all move earnings between periods.

Physician groups on cash-basis tax returns are especially exposed. Management books may be hybrid. QoE will put the practice on a consistent accrual basis for the trailing twelve months. The delta can be material.

This is the gap between bookkeeping and a CFO view described in Beyond Bookkeeping. Tax-basis statements are not a substitute for a management P&L that a buyer can trust.

How to get through a QoE without giving up the multiple

Eighteen months is a realistic runway. In that window a fractional CFO typically:

• Rebuilds management reporting so clinical operations, real estate, and owner items are visible separately.
• Produces a monthly provider and location P&L.
• Documents an EBITDA bridge with support for every adjustment.
• Cleans A/R, credit balances, and denial work queues.
• Benchmarks compensation and related-party rent.
• Runs a mock QoE before bankers or buyers do. That is core sale-preparation work.

None of that requires a signed LOI. It does require someone who has sat on both sides of a healthcare transaction and knows which adjustments are worth fighting.

Conclusion

Quality of earnings is not a surprise attack. It is a structured search for earnings that will not travel with the practice. Compensation, add-backs, revenue cycle, concentration, related-party rent, working capital, and cutoff are where that search lands in medical groups.

Owners who treat QoE as a last-minute accounting project negotiate from a weaker position. Owners who treat it as an operating discipline—the same discipline in what you are really buying when you hire a fractional CFO—usually keep more of the multiple they thought they had.

Ready to tighten the numbers behind these decisions? Schedule a conversation with Black Diamond CFO Solutions.

FAQs

What is a quality of earnings report in a physician practice?

It is an independent review, usually commissioned by a buyer or lender, that tests whether reported or adjusted EBITDA is sustainable and transferable. It is narrower than an audit and more focused on cash earnings, add-backs, and customer or provider concentration.

How long does QoE take?

Four to eight weeks is common once a data room is populated. The calendar stretches when A/R detail, provider compensation files, or related-party leases are incomplete.

Should the seller conduct its own QoE review?

A sell-side or “mock” QoE is often worth the cost on deals above a few million of EBITDA. It surfaces issues while there is still time to fix operations rather than negotiate a price cut.

Does cash-basis accounting fail a QoE?

Not by itself. The QoE team will convert results to accrual for the period under review. The risk is the size of that conversion, not the tax method.

Categories: Financial Reporting, Healthcare Finance