Financial Diligence

The Quality of Earnings report directly dictates final purchase price adjustments and protects buyers from overpaying for inflated performance. This skill automates the foundational labor of financial due diligence.

When to Use

Performing a Quality of Earnings analysis on a target
Validating management-proposed EBITDA adjustments
Reconciling trial balances against audited financials and tax returns
Identifying off-balance-sheet liabilities and debt-like items
Analyzing net working capital for purchase agreement peg negotiations

Quality of Earnings Report Structure

| Section | Focus | |---------|-------| | Quality of Earnings Summary | Bridge between reported and run-rate adjusted EBITDA | | Revenue & Margin Analysis | Customer concentration, product mix, volume vs. price trends | | EBITDA Adjustments | Validate or refute each management add-back | | Net Working Capital (NWC) | Historical peg calculation, seasonality, aged receivables, obsolete inventory | | Debt and Debt-Like Items | Off-balance-sheet liabilities, deferred revenue, unpaid bonuses, unfunded capex |

AI-Assisted Workflow

Trial Balance Reconciliation

Ingest trial balances, audited financials, bank statements, and tax returns (3-5 year lookback)
Map granular account codes to standard FDD analytical groupings
Reconcile across data sources, flagging discrepancies
Detect anomalies — sudden expense spikes, unusual journal entries near deal launch

EBITDA Adjustment Analysis

For each proposed management add-back:

## EBITDA Bridge

### Reported EBITDA: $[X]M

| # | Adjustment | Amount | Category | Defensibility | Notes |
|---|-----------|--------|----------|---------------|-------|
| 1 | Owner excess compensation | $[X]K | Recurring normalization | HIGH | Benchmarked against market rate |
| 2 | One-time litigation | $[X]K | Non-recurring | HIGH | Settlement confirmed, no ongoing exposure |
| 3 | "COVID impact" | $[X]K | Disputed | LOW | Revenue decline appears structural |
| ... | ... | ... | ... | ... | ... |

### Adjusted EBITDA: $[X]M
### Buy-Side Recommended EBITDA: $[X]M (variance: $[X]K)

Net Working Capital Analysis

## NWC Peg Analysis

### Trailing 12-Month Average NWC: $[X]M

| Component | Avg Balance | Seasonality | Flags |
|-----------|------------|-------------|-------|
| Accounts Receivable | $[X]M | [Pattern] | [Aged AR > 90 days: $X] |
| Inventory | $[X]M | [Pattern] | [Obsolete: $X] |
| Prepaid Expenses | $[X]M | | |
| Accounts Payable | ($[X]M) | | [Stretched beyond terms?] |
| Accrued Liabilities | ($[X]M) | | |

### Recommended NWC Target: $[X]M
### Mechanism: [Dollar-for-dollar adjustment / collar]

Operating Guidelines

Always validate management's reported EBITDA independently — never accept at face value
Distinguish between truly non-recurring items and items management wishes were non-recurring
Flag revenue recognition policy changes during the lookback period
Identify related-party transactions and verify arm's-length pricing
For NWC, exclude cash and debt from the calculation unless specified in the purchase agreement
AI outputs are analytical aids — the subjective debate over valid add-backs requires human judgment
Time saved: automates tie-out process that traditionally takes 40+ hours

Examples

Input: "Run a QoE analysis on this target's three-year P&L."

EBITDA bridge output: | Item | Amount | Type | |---|---|---| | Reported EBITDA | $18.2M | — | | + Owner salary above market | +$1.2M | Non-recurring | | – One-time insurance recovery | –$0.8M | Non-recurring | | – Understated capex (lease restructure) | –$1.4M | Run-rate | | Adjusted EBITDA (QoE) | $17.2M | — |

Finding: Reported EBITDA overstated by $1.0M (5.5%) — material enough to impact valuation by ~$10M at 10x multiple.

Troubleshooting

| Problem | Cause | Fix | |---|---|---| | Trial balance doesn't tie to P&L | Accounting errors or plug entries | Request a full GL export; flag any journal entry >5% of EBITDA without documentation | | Working capital peg disputes | Different normalization methodologies | Align on peg definition (12-month average vs. spot) in the LOI | | Revenue recognized incorrectly | ASC 606 misapplication | Engage accounting advisors for revenue recognition memo | | Hidden liabilities in debt schedule | Off-balance-sheet items | Request all operating leases, earnouts, and contingent liabilities |