Quality of earnings adjustments: a practitioner’s list for sell-side due diligence
The adjustment bank we work through on every mandate — 32 adjustments in seven groups, each with its trigger, how it is measured and the evidence a buyer will ask for — plus how to present an EBITDA bridge that survives the buyer’s review.
What a quality of earnings analysis is
A quality of earnings (QoE) analysis answers a simple question: of the profit the accounts report, how much reflects the ongoing, stand-alone earning power of the business a buyer is acquiring? Statutory accounts are prepared for tax, compliance and the owner’s purposes. They include the owner’s car, the settlement from a dispute two years ago, the rent the company never paid on the shareholder’s building, and revenue recognised in the wrong month. None of that is wrong; it is simply not what a new owner will earn.
The output of a QoE analysis is a single table — the EBITDA bridge — that starts from reported EBITDA, lists every adjustment with an amount, a category and a source document, and ends with adjusted EBITDA. In a sell-side process the bridge is prepared before the buyer arrives, normally as the core of the financial chapter in a vendor due diligence report.
Why buyers price off adjusted EBITDA
In private-company transactions the headline price is almost always expressed as a multiple of earnings, and EBITDA is the common denominator because it is independent of capital structure and depreciation policy. The multiple is negotiated; the earnings figure it is applied to is supposed to be a fact. That is why the bridge matters so much. Every adjustment is effectively multiplied by the deal multiple: an unsupported add-back is not a small number in the P&L, it is a multiple of that number off the price once the buyer’s advisor removes it.
Buyers also use adjusted EBITDA to size acquisition debt, to design any earnout, and to decide which findings become price adjustments rather than warranties. How findings turn into contract terms is covered in our companion guide to SPA mechanics for sellers.
The adjustment bank: 32 adjustments in seven groups
The list below is the adjustment bank we work through on every mandate. Not every adjustment applies to every company, but each one should be considered and either quantified or recorded as not applicable. Groups A, B, C, D and G change EBITDA; groups E and F do not, but they produce the working capital peg, the capex figure and the net debt bridge that convert EBITDA into the price the seller actually receives. For each adjustment the table shows what triggers it, how it is measured, and the evidence a buyer’s advisor will ask to see.
AOwner-related
The most common adjustments in owner-managed businesses, and the ones buyers test hardest, because they are where the owner’s personal and business finances meet.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| A1 | Owner remuneration above or below market | The managing director or finance lead is the owner or related to the owner. | Market salary for a comparable role and experience, fully loaded, × 12 months, less actual cost. Can go either way. | Payroll records, the owner’s employment terms, a salary benchmark for the role. |
| A2 | Relatives on the payroll without a role | A spouse, child or sibling is paid but has no operational function. | Full add-back of salary and employer charges; partial if there is a genuine but smaller role. | Payroll by name, job descriptions, evidence of actual work. |
| A3 | Private expenses run through the business | Cars, travel, home maintenance, subscriptions or similar booked as company cost. | Line-by-line analysis of the ledger accounts concerned; only items with no business purpose are added back. | Ledger extracts, invoices, expense policy. |
| A4 | Owner-owned property leased below market | The company occupies the shareholder’s property rent-free or at below-market rent. | Deduct market rent (floor area × market rate × 12), add back property costs the company carried as owner-equivalent. Value the property separately. | Lease (or the absence of one), floor area, market rent evidence, property cost ledger. |
| A5 | Personal guarantees on company debt | The owner guarantees loans or leases that the buyer will have to refinance or replace. | Not an EBITDA line: record the guaranteed amount and any guarantee fee, and carry it to net debt. | Loan and lease agreements, guarantee documents. |
BNon-recurring items
Income and costs that will not repeat under new ownership. The test is recurrence, not whether the item feels unusual.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| B1 | One-off income | Litigation settlements, insurance proceeds, grants, exceptional FX or disposal gains. | Deduct the amount recognised in EBITDA in the period it fell. | Settlement agreement, insurer’s letter, grant decision, ledger posting. |
| B2 | One-off costs | Restructuring, redundancy, transaction advisory fees, exceptional repairs. | Add back only what will not recur; repeating “one-offs” are run-rate cost. | Invoices, board minutes, a three-year history showing the item does not repeat. |
| B3 | Pandemic-era or crisis effects | Lost revenue, temporary support, deferred wages in an exceptional period. | Deduct support income; show the affected period separately and state any claw-back risk. | Support decisions and conditions, monthly revenue before and after. |
| B4 | Implementation costs | A new ERP, product launch or system migration expensed in the year. | Add back if genuinely non-recurring and not replacing an ongoing cost. | Project budget, invoices, evidence of completion. |
| B5 | Prior-year tax settlements | Tax or penalty adjustments for earlier years booked through operating costs. | Add back from EBITDA; carry any unpaid amount to net debt. | Tax authority correspondence, assessments, ledger. |
CAccounting policy
Adjustments that put every year on the same, correct basis, so that the trend in the bridge is real.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| C1 | Change in accounting policy | A policy changed during the review period, breaking comparability. | Restate the earlier years on the current policy (or vice versa). | Accounting policy notes, auditor’s letter, reconciliation. |
| C2 | Revenue recognition | Over time versus point in time, principal versus agent, cut-off at period end. | Re-time or re-gross revenue to the correct period and basis. | Contracts, delivery records, invoices around the year end. |
| C3 | Cost accruals and prepayments | Costs booked when paid rather than when incurred, or not matched to revenue. | Move cost to the period it relates to. | Accruals schedule, supplier invoices after period end. |
| C4 | Depreciation and impairment | Useful lives out of line with reality; impairments hidden in operating cost. | Test depreciation against the asset register; reassess the maintenance capex it implies. | Fixed asset register, depreciation policy, capex history. |
| C5 | Inventory valuation | Slow-moving or obsolete stock carried at cost; valuation method inconsistent. | Write down to lower of cost and net realisable value, using the stock ageing. | Stock list with ageing, count results, sales of aged items. |
| C6 | Receivables provisioning | Provisions not supported by the debtor ageing, or written off in a single year. | Rebuild the provision from the ageing and spread the true bad-debt cost. | Debtor ageing, write-off history, credit notes after period end. |
DRelated parties
Transactions with the owner and connected companies, restated to what an independent party would pay or charge.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| D1 | Sales to related parties off market | Customers owned by the shareholder or family pay more or less than third parties. | Restate to arm’s-length price; consider whether the volume will continue. | Related-party schedule, price lists, comparable third-party invoices. |
| D2 | Purchases from related parties off market | Suppliers connected to the owner charge above or below market. | Restate to arm’s-length cost. | Supplier contracts, third-party quotes. |
| D3 | Intra-group or shareholder loans at non-market rates | Loans to or from the owner or sister companies at low or nil interest. | Recalculate at a market rate; the loan itself goes to net debt or is settled before completion. | Loan agreements, interest postings, balances by month. |
| D4 | Shared staff and services | People, premises or systems shared with other companies of the owner. | Allocate a fair share of cost, or add the stand-alone cost the business will need. | Allocation keys, timesheets, service agreements. |
EWorking capital and capex
Not EBITDA adjustments, but the analysis that tells a buyer how much cash the earnings actually produce.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| E1 | Target net working capital (peg) | Always — the peg sets the level of working capital delivered at completion. | Twelve-month average of monthly NWC, adjusted for seasonality, excluding cash, debt and corporate tax. Show sensitivity. | At least 24 monthly balance sheets. |
| E2 | Deposit and prepayment patterns | Customer deposits or supplier prepayments that swing seasonally. | Use the full twelve-month profile rather than a single month to avoid distortion. | Monthly deposit and prepayment balances. |
| E3 | Maintenance versus growth capex | Always — buyers convert EBITDA to cash with maintenance capex. | Split historical capex; the three-to-five-year average of maintenance capex is the recurring cash cost. | Capex listing by project with purpose. |
FDebt normalisation
The items that sit between enterprise value and the equity price on a cash-free, debt-free basis.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| F1 | Interest-bearing debt | Bank loans, bonds, overdrafts, finance leases, accrued interest. | Balance at the reference date. | Loan statements, agreements, covenant terms. |
| F2 | Debt-like items | Obligations that are not loans but reduce what the seller receives. | Walk through the full list and record “not applicable” where relevant. | Tax filings, payroll, provisions, contracts. |
| F3 | Cash-like items | Cash above the minimum the business needs to operate. | Total cash less operating minimum; restricted cash and deposits are excluded. | Bank statements, monthly cash profile. |
| F4 | Related-party debt | Balances owed to or from the owner or connected companies. | Treat as debt or settle before completion; exclude any non-arm’s-length element. | Related-party loan schedule. |
| F5 | Deferred revenue | Customers have paid for a service not yet delivered. | Treat as debt-like where the buyer bears the cost of delivery. | Deferred revenue roll-forward, contracts. |
| F6 | Deferred consideration | Earnouts or instalments still owed on the company’s own earlier acquisitions. | Present value of the expected payments. | Previous SPAs, earnout calculations. |
GPro forma and run-rate
Adjustments that make EBITDA reflect the business as it stands today, rather than as it stood on average over the period.
| # | Adjustment | Trigger | How it is measured | Evidence a buyer will ask for |
|---|---|---|---|---|
| G1 | Acquired or discontinued operations | A business bought or closed during the period. | Annualise acquisitions to a full year; remove discontinued activities. | Acquisition date and accounts, closure decision, segment P&L. |
| G2 | Stand-alone costs | Costs the owner or a parent carried that the business will bear after the sale (accounting, IT, insurance, management). | Deduct the expected stand-alone cost. | Current service arrangements, quotes for replacements. |
| G3 | Confirmed cost savings | A saving the seller wants credit for. | Include only if the action is taken and the saving is visible in the monthly numbers; otherwise show separately, outside adjusted EBITDA. | Monthly cost lines before and after, signed decisions. |
Adjustments that reduce EBITDA — and why a seller must include them
A seller-side bridge that only adds back is the fastest way to lose credibility. Experienced buyers expect to find adjustments in both directions, and if the seller’s bridge contains none that reduce EBITDA, the buyer’s advisor will assume the work is advocacy rather than analysis and re-perform all of it. The downward adjustments that appear most often are:
- Owner remuneration below market (A1). An owner who pays themselves little flatters EBITDA; the replacement manager will not work for that.
- Rent on owner-occupied property (A4). If the company uses the shareholder’s building for free, a market rent comes off EBITDA — and the property is valued separately.
- One-off income (B1) and crisis-era support (B3). Grants, insurance proceeds and settlement income do not recur.
- Under-provisioned receivables and stock (C5, C6). A clean-up in the final year shifts cost into the period the buyer will look at most closely.
- Related-party sales above market (D1). Revenue from a connected customer at a premium price will not survive the sale.
- Stand-alone costs (G2). The accounting, IT and insurance the owner’s other companies provided at no charge.
Including these is not generosity. The buyer will find them anyway; the question is only whether the seller quantified them first.
How to present the EBITDA bridge
Presentation is part of the evidence. A bridge that a buyer can follow line by line, and trace back to a document, gets accepted far more often than one that has to be explained in a meeting. The conventions we use:
- Three financial years plus the current year to date, so the buyer sees both the trend and the latest run-rate. Where the year to date is short, add the last twelve months.
- One line per adjustment, numbered to the adjustment bank, with its category (add-back or deduction) and a source per line: document name and page, or ledger account.
- Reported EBITDA reconciled to the audited accounts at the top, so there is no argument about the starting point.
- The multi-year average of adjusted EBITDA stated at the bottom, alongside the latest year, because buyers in owner-managed deals often price off the average rather than the peak.
- Items considered but not adjusted listed in a note, with the reason. It shows the work was complete.
| # | Line | Category | Year 1 | Year 2 | Year 3 | YTD | Source |
|---|---|---|---|---|---|---|---|
| — | Reported EBITDA | — | … | … | … | … | Audited accounts |
| A1 | Owner remuneration to market | Deduction / add-back | … | … | … | … | Payroll; salary benchmark |
| B2 | Transaction advisory fees | Add-back | … | … | … | … | Invoices; ledger account |
| G2 | Stand-alone costs | Deduction | … | … | … | … | Service quotes |
| — | Adjusted EBITDA | — | … | … | … | … | — |
| — | Average, three years | — | … | — | |||
Common mistakes
- Recurring “one-offs”. A restructuring cost that appears every year is a cost of doing business. Show three years of history before calling anything non-recurring.
- Add-backs without documents. An adjustment the seller cannot evidence will be removed, and every other adjustment will be questioned. If there is no document, there is no adjustment.
- Anticipated savings inside adjusted EBITDA. Savings from actions not yet taken belong in a separate line or in the business plan, not in the bridge.
- Mixing EBITDA and net debt. A personal guarantee or an unpaid tax bill is not an EBITDA adjustment; double counting them in both places invites a reprice.
- Management accounts that do not reconcile. If reported EBITDA in the bridge does not agree to the audited accounts, the discussion starts with the starting point, not the adjustments.
- No monthly data. Without monthly P&L and balance sheets the buyer cannot verify the run-rate or set the peg, and will fill the gap with assumptions of its own. Our sell-side due diligence checklist lists the documents that support each adjustment.
How AI drafts a first bridge — and what the advisor still decides
Most of the time in a QoE analysis goes into finding the evidence: reading the ledger for unusual postings, matching payroll to names and roles, reading leases for the rent and the landlord, tracing related-party invoices, comparing monthly revenue around the year end. That is reading and matching across hundreds of documents, which is where a language model constrained to the data room — and required to cite — is genuinely useful.
In SellSide DD the system works through the adjustment bank against the documents in the room. It proposes candidate adjustments it can evidence, each with an amount per year and a link to the source page; it flags adjustments it suspects but cannot evidence as data requests; and it lists the adjustments it considered and found not applicable. The result is a draft bridge on the first day of the engagement instead of the third week.
What the model does not do is decide. Whether a cost is genuinely non-recurring, what market salary is appropriate for the owner’s role, whether a related-party price is arm’s length, how much stand-alone cost the business will really need, and whether a saving is visible enough to include — these are judgements, and they belong to the advisor, who accepts, edits or rejects each line. The advisor also decides how the bridge is presented to buyers and which items are disclosed with an explanation rather than adjusted. The model gives the advisor a complete, cited starting point; the published bridge reflects the advisor’s view.
Frequently asked questions
What is the difference between a quality of earnings report and an audit?
An audit gives an opinion on whether the statutory accounts are prepared in accordance with the applicable framework. A quality of earnings analysis takes those accounts as its starting point and asks a different question: which parts of the reported profit will continue under new ownership. It adjusts for owner-related items, one-off events, accounting policy, related parties and run-rate changes, and it is written for a transaction rather than for compliance.
Which quality of earnings adjustments are most common in owner-managed businesses?
Owner remuneration to market, private expenses run through the business, rent on property owned by the shareholder, relatives on the payroll, one-off income and costs, and related-party transactions at non-market prices. Stand-alone costs are frequently missed: the accounting, IT or insurance that the owner’s other companies provided at no charge.
Should a seller include adjustments that reduce EBITDA?
Yes. A buyer’s advisor will find them regardless, and a bridge that only adds back is treated as advocacy and re-performed in full. Including downward adjustments — below-market owner salary, missing rent, one-off income, stand-alone costs — is what makes the add-backs credible.
How many years should an EBITDA bridge cover?
Three financial years plus the current year to date, with the last twelve months where the year to date is short. State both the latest year and the multi-year average of adjusted EBITDA, because buyers of owner-managed businesses often price off the average.
Are cost savings ever accepted in adjusted EBITDA?
Only where the action has already been taken and the saving is visible in the monthly numbers. Planned or expected savings should be shown separately, outside adjusted EBITDA, where the buyer can assess them as part of the business plan.
Can AI prepare a quality of earnings analysis?
It can prepare a first draft. A model constrained to the data room can propose evidenced adjustments with sources, flag suspected adjustments as data requests and list what it found not applicable. The judgements — recurrence, market rates, arm’s-length prices, stand-alone costs and presentation — remain with the advisor, who signs off every line.