Appendix: Financial Due Diligence (Quality of Earnings)

Adjusted (normalized) EBITDA is reported EBITDA plus or minus a schedule of adjustments, each intended to move the number closer to sustainable earnings. The adjustments, commonly called add-backs even when some reduce the figure, tend to fall into recognizable categories:

• Owner compensation above (or below) market. A founder who pays themselves well above a market salary for the role depresses reported earnings; normalizing to a market rate adds the excess back. The reverse happens when an owner takes little or no salary.
• One-time items. A litigation settlement, a failed system implementation, or non-recurring professional fees inflate expenses in a single period. If the item is genuinely non-recurring, it is added back so it does not drag the run-rate a buyer inherits.
• Run-rate adjustments. A price increase or a headcount change that took effect partway through the year is annualized so the figure reflects a full year at the new level, in either direction.
• Related-party normalization. Rent paid to a building owned by the seller, or a management fee charged by an affiliate, may sit above or below a market rate. Normalizing it to market removes a benefit or burden that will not travel with the business.

The discipline in each category is the same. An add-back is only as good as its support, and a buyer tends to challenge each one, because each dollar added to EBITDA is multiplied into the price.

Two deal terms ride alongside the earnings number. The first is the net-working-capital peg. A business needs a normal level of working capital (receivables plus inventory less payables, broadly) to run day to day, and the buyer expects to receive the target with roughly that level in place. The peg is a target working-capital level set in the purchase agreement, frequently a trailing average such as the last twelve months, because a single month-end can be unrepresentative. At close, actual working capital is compared to the peg, and a true-up adjusts the price: deliver less than the peg and the price is reduced, deliver more and it rises. The true-up mechanism is a standard term in private-company purchase agreements.

The second is debt-like items: obligations that behave like debt even when they are not labeled as such, for example accrued but unpaid bonuses, deferred revenue the buyer will have to service, unfunded liabilities, or deferred capital spending. These sit outside EBITDA but reduce the equity value a buyer will pay, so diligence flags them separately in the bridge from enterprise value to equity value. Missing one is a classic way a buyer overpays.

Define the finish line before any tool touches the data. A buyer-defensible quality-of-earnings analysis has four properties. The bridge foots, so reported EBITDA plus the net adjustments equals adjusted EBITDA to the dollar. Each add-back is supported, so there is a documented basis a buyer could test rather than an assertion. Each adjustment is correctly labeled one-time or run-rate, so the reader can judge what persists. And the number is ownership-neutral, restating away benefits and burdens specific to the current owner rather than padding the figure to lift the price.

Here is why the task suits AI assistance. Once the adjustment schedule exists, much of the remaining work is mechanical and linguistic: totaling the bridge, averaging twelve months of working capital, labeling each item, and drafting a clear support note in a diligence voice. The judgment, whether an add-back is defensible, whether a cost is truly non-recurring, and what the numbers imply, is where the analyst adds value. That split, deterministic arithmetic on one side and judgment plus narrative on the other, is what the rest of this appendix is built around.