financial-diligence

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

1. Ingest trial balances, audited financials, bank statements, and tax returns (3-5 year lookback)
2. Map granular account codes to standard FDD analytical groupings
3. Reconcile across data sources, flagging discrepancies
4. 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