Financial due diligence (FDD), typically delivered as a quality of earnings (QoE) report, is an independent analysis that tests whether a company's reported profits reflect its true, repeatable earning power. It rebuilds the income statement from source records, strips out one-time, non-operating, and owner-specific items, and arrives at a normalized figure called adjusted EBITDA. In a sell-side M&A process it is one of the most decisive documents you bring to the table, because it defines the earnings number that a valuation multiple gets applied to, and therefore your price.
The QoE analysis is the core deliverable of the broader FDD workstream, and the goal of both is the same: convert accounting profit into a defensible measure of how much cash the business actually throws off in a normal year. Buyers and their lenders do not price a company on the net income line of a tax return; they price it on what they believe the business will repeatably earn under new ownership. The FDD report is the bridge between those two numbers. Below is what a credible report contains, how add-backs work, the sign convention that keeps it honest, and why running one before you go to market changes the outcome of a deal.
What a financial due diligence (QoE) report actually contains
A financial due diligence report does not restate your books or audit them for GAAP compliance. Instead, it independently reconstructs earnings to show a buyer what the business really earns. A thorough report typically includes:
- Quality of earnings analysis: the core exercise of normalizing reported net income or EBITDA into adjusted EBITDA by identifying add-backs and deductions.
- Revenue analysis: trends by product, customer, and period; recurring vs. one-time revenue; and customer concentration (how much of revenue rides on a few accounts).
- Margin and cost analysis: gross and operating margins over time, with unusual swings explained.
- Net working capital: a normalized level of working capital the business needs to operate, which sets the peg used at closing.
- A proof of cash, which reconciles reported revenue and profit to actual bank deposits, confirming the earnings are real and not just entries in the ledger.
- Debt and debt-like items: obligations a buyer will assume or need to settle at close.
The heart of the report is the quality of earnings analysis, and the heart of that is the add-back schedule. A report also usually presents earnings on a trailing-twelve-month (TTM) basis alongside prior full years, so a buyer can see the most current run-rate rather than a stale year-end snapshot.
EBITDA add-backs explained
Owner-operated private companies are usually run to minimize taxes and reflect the owner's lifestyle, not to maximize reported profit. Add-backs correct for that. An add-back is an adjustment that removes an expense (or income item) that a new owner would not incur in the same way, so the earnings figure reflects the business as it would run under normal, arm's-length ownership.
Common categories of EBITDA add-backs include:
- Owner compensation vs. market: if the owner pays themselves $500,000 but a hired manager doing the same job would cost $200,000, the $300,000 difference is added back. If the owner is underpaid relative to market, the adjustment runs the other way.
- One-time and non-recurring items: a lawsuit settlement, a one-off consulting project, severance, a bad-debt write-off, or the cost of a flood that won't repeat.
- Related-party rent: if the company rents a building the owner also owns at above- or below-market rent, the expense is normalized to a market rate.
- Personal or discretionary expenses: a personal vehicle, travel, club memberships, or family members on payroll who don't work in the business.
- Investment gains, interest income, and other non-operating income and expense items are removed because they are unrelated to core operations and won't transfer with the business.
| Add-back category | Example | Effect on adjusted EBITDA |
|---|---|---|
| Excess owner compensation | Owner paid $300K above market rate | Increase |
| One-time legal settlement | $120K lawsuit paid last year | Increase |
| Above-market related-party rent | Rent $60K over market to owner's LLC | Increase |
| Personal expenses run through the business | Personal auto and travel of $40K | Increase |
| Non-operating investment income | $25K of interest income | Decrease |
| Below-market owner compensation | Owner underpaid by $100K | Decrease |
Sign convention: what increases vs. decreases adjusted EBITDA
Not every adjustment adds to earnings. Getting the direction right is what separates a defensible report from an inflated one.
Adjustments that increase adjusted EBITDA remove an expense that overstates the true cost of running the business: excess owner pay, above-market rent, one-time expenses that won't recur, personal expenses, and discretionary spending a buyer would cut.
Adjustments that decrease adjusted EBITDA remove income that won't continue or add back a real cost the business currently avoids: non-operating income, below-market owner compensation (a buyer must pay a manager fairly), below-market rent that will rise to market, and one-time revenue that inflated a strong year.
A credible report shows the deductions as clearly as the increases. A schedule that only ever adds to earnings is a red flag to any buyer's accountant.
Sell-side vs. buy-side FDD (why doing it first pays off)
The same analysis can be commissioned by either party, but the timing changes how it is used.
- Buy-side due diligence is run by the buyer after a deal is in motion. Its purpose is to find problems that justify a lower price, tighter terms, or a bigger holdback. Whatever the buyer's team turns up, the seller is reacting to it under deadline pressure.
- Sell-side due diligence is commissioned by the seller before going to market. It surfaces the same issues first, on the seller's timeline, so they can be fixed or documented in advance rather than discovered.
Running sell-side due diligence before you launch a process pays off in several ways. You set the adjusted EBITDA figure with evidence behind it, so negotiations start from your number rather than the buyer's. You avoid surprises that stall or kill deals during the buyer's diligence, and you keep negotiating leverage instead of conceding price under a deadline. And you shorten the timeline, because a buyer's accountant can validate a well-supported report far faster than they can build one from scratch. A weak or missing earnings story is one of the most common reasons lower-middle-market deals fall apart in diligence, and a re-trade (the buyer lowering their offer late in the process after finding unsupported adjustments) is far harder to pull off against a seller who documented the numbers first.
How adjusted EBITDA and the multiple drive your price
Most private companies in the lower middle market are valued on a simple formula:
Enterprise value ≈ adjusted EBITDA × valuation multiple.
Because the two terms multiply, the earnings figure and the multiple compound each other. Suppose a business shows $1.5 million of adjusted EBITDA after legitimate add-backs, versus $1.2 million on the unadjusted books. At an illustrative multiple of 5x, that $300,000 of defensible add-backs is worth about $1.5 million in enterprise value ($300,000 × 5). The same logic works in reverse: if a buyer's accountant disallows add-backs your report couldn't support, both the earnings and the value tied to them evaporate.
This is why the earnings figure deserves as much attention as the negotiation over the multiple itself. Sellers often focus entirely on pushing the multiple up, but a single well-supported add-back the buyer accepts can add more to enterprise value than a fraction of a turn on the multiple. And unlike the multiple, it is grounded in evidence rather than persuasion.
Valuation multiples vary widely by industry, size, growth, customer concentration, and deal terms; smaller companies generally trade at lower multiples than larger ones. The figures above are general educational estimates, not an appraisal or a prediction of the value of any specific business.
What makes a financial due diligence report credible
A report only helps if it survives scrutiny from the buyer's accountants. Credibility comes from evidence and defensibility, not from the size of the adjustments.
- Every add-back is cited to source evidence (payroll records, invoices, lease agreements, bank statements, and tax returns), not asserted.
- Adjustments are normal-course and repeatable in logic: each reflects how the business would run under new ownership, and would be recognized as legitimate by an independent accountant.
- Earnings tie to the bank through a proof of cash, with reported profit reconciling to actual deposits.
- Increases and decreases both appear in the schedule, so the report reads as balanced analysis rather than advocacy.
- There is a human review gate: a qualified reviewer stands behind the numbers and can defend them in negotiation.
Bankerly.ai offers a financial due diligence (QoE) report as part of its sell-side process, with a human review gate before the report is finalized. Whoever prepares it, the standard is the same: a report a buyer's accountant can validate line by line is worth far more than a bigger adjusted EBITDA number no one can defend.
The bottom line
A quality of earnings report turns your accounting profit into the number a deal is actually priced on. Because value is adjusted EBITDA times a multiple, disciplined, well-evidenced add-backs are among the highest-leverage work you can do before selling. Start the work early and cite everything. Show the deductions as honestly as the increases, and you walk into negotiations with a price that holds up.
Frequently asked questions
- What is a quality of earnings report?
- A quality of earnings (QoE) report, the core deliverable of financial due diligence, is an independent analysis that tests whether a company's reported profits reflect its true, repeatable earning power. It reconstructs earnings from source records, removes one-time and owner-specific items, and produces adjusted EBITDA, the figure buyers use to price a deal.
- What are EBITDA add-backs?
- EBITDA add-backs are adjustments that remove expenses a new owner would not incur, so earnings reflect normal, arm's-length operations. Common examples include excess owner compensation, one-time legal or severance costs, above-market related-party rent, and personal expenses run through the business. Each legitimate add-back increases adjusted EBITDA when supported by evidence.
- What is adjusted EBITDA?
- Adjusted EBITDA is earnings before interest, taxes, depreciation, and amortization, further normalized to remove items that will not recur under new ownership. It approximates the repeatable cash earning power of a business in a normal year. In most lower-middle-market deals, enterprise value is estimated as adjusted EBITDA multiplied by a valuation multiple.
- Do I need a QoE report to sell my business?
- It is not legally required, but a sell-side quality of earnings report strongly benefits most sellers. It sets your adjusted EBITDA with evidence behind it, surfaces problems before a buyer does, and speeds up the buyer's diligence. Without one, a buyer's accountants control the earnings narrative, often to justify a lower price.
- How much does a quality of earnings report cost?
- Cost varies with company size, transaction complexity, and provider. Traditional accounting-firm engagements for lower-middle-market companies can run into the tens of thousands of dollars, while software-driven providers aim to deliver comparable analysis at lower cost. Weigh the fee against the enterprise value that well-supported add-backs can protect in negotiation.
Considering a sale in the next few years? See what a prepared process looks like.
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