Due Diligence

Quality-of-earnings Mechanics

What a quality-of-earnings analyst actually does for four weeks — the four workstreams, the bridge schedule, and the adjustments that move price in both directions.

  • Advanced
  • 9 min total
  • 13 chapters

What decision this helps you make: What number you are buying at, what the working capital target should be, and which of the seller's add-backs survive contact with the bank statements.

What this topic is

A quality-of-earnings analysis is not an audit and produces no opinion. It is a set of procedures that rebuilds a seller's earnings from source records into a defensible Adjusted EBITDA, sets a working capital target, and lists everything debt-like that has to be settled at closing. The deliverable that matters is a spreadsheet, not a narrative.

Why it matters

The price is a multiple of the number the analysis produces. At five and a half times earnings, every $100,000 of adjustment is $550,000 of purchase price — and the working capital target, negotiated in the same weeks, routinely moves as much money as the add-backs do.

Who should learn it

Buyers running a deal, sellers preparing for one, lenders relying on the output, and operators who want to know what a diligence team is doing with their general ledger.

What you will understand

  • Follow the four workstreams: proof of cash, the bridge, working capital, debt-like items
  • Build an EBITDA bridge and mark which adjustments are supportable
  • Find the adjustments that move earnings DOWN — the ones sellers never volunteer
  • Set and defend a working capital target, and know how the true-up settles it

Prerequisites

Common misconception

"Diligence is where the buyer finds the fraud." Fraud is rare. What a quality-of-earnings analysis almost always finds is ordinary: a seller's salary that has to be replaced at market, rent charged below market by a related entity, paid time off never properly accrued, revenue booked a week before it was earned, and repairs sitting in the fixed-asset ledger. None of it is dishonest. All of it changes the number you are paying a multiple of.