Quality of Earnings Due Diligence for Buying and Selling a Business

A Quality of Earnings report is a deal-focused, non-attest analysis that tests whether a target company’s reported earnings reflect real, recurring cash flow. It rebuilds management’s numbers: it normalizes EBITDA for one-time and owner-specific items, proves the cash against the bank, and prices the working capital the business needs to keep running after close.

It is not an audit (no opinion, no assurance), not a valuation (it produces the normalized EBITDA a valuation is built on, but stops short of a value), and not tax or legal due diligence. Treewalk runs the financial diligence and partners with a CBV firm for valuation and a tax firm for tax diligence, so a buyer gets one coordinated process instead of three disconnected ones.

For sellers, the highest-value timing is before you go to market, never after you are already deep in a buyer’s exclusivity period. A completed sell-side QoE widens the buyer pool, shortens diligence, and prevents the most common way a deal dies: a buyer spends ninety days under exclusivity, the financials come back soft, and they walk after two extensions. Our goal is that when you accept an offer, the financials are the one thing that will not be the deal-killer.

For buyers, the trigger is post-LOI: once you have an accepted letter of intent and exclusivity, before you remove your diligence condition.

There are two ways to receive a QoE:

The QoE data book (Excel). Every schedule, adjustment, proof-of-cash detail, and working-capital calculation. For most of the owner-managed, lower-middle-market deals we work on, this is the right deliverable. It is the same level of diligence as a full report, it is lender-compatible, and it costs less because it skips the formatting overhead.

The full PDF report. The data book’s findings turned into a narrative with tables and graphs. It makes sense for larger deals, private-equity buyers, complex capitalization tables, or when a specific lender or investor requires it.

A long formatted report is overkill for a small owner-managed business. Most lower-middle-market buyers are well served by the data book.

These are the recurring patterns we see across SMB deals (illustrative composites, not any single client):

• Pre-sale expense dips. Two or three months of unusually low costs right before a sale. It is a recurring enough pattern that we test for it on every engagement.
• Year-end revenue stuffing. A large deposit invoiced days before year-end that is almost entirely unearned.
• Add-backs that do not trace. A claimed cost with no entry in the general ledger; a “reconciliation discrepancy” that turns out to be an accounting-system migration artifact; double-counted payroll from running two accounting files at once.
• Sublease and other non-operating income booked as revenue, which has to be stripped out to isolate the business.
• Rent and insurance understated versus what a new owner will actually pay on a standalone basis.
• Customer concentration hiding in the revenue, and one-time projects dressed up as recurring.
• Working capital the seller underestimates. Owners consistently think a business runs on less working capital than it actually needs.

The point of naming these is not suspicion. As one of our directors puts it, most of it is “things small businesses do that the seller did not know how to deal with,” not manipulation. But each one moves EBITDA, and EBITDA moves price.

Every engagement runs the same spine, sized to the deal:

Buyers ask whether our adjustments are aggressive or conservative. The honest answer is fair across the board. On the sell-side, the work is a partnership to maximize value within reason. We will not declare EBITDA a million dollars higher to win a mandate, the way some sell-side shops add back everything that moves. The number has to hold up in the buyer’s diligence, or it was never worth anything.

Two areas cause more last-minute disputes than any other.

Deferred revenue. Cash a seller collected for work not yet delivered is a liability, not profit. The most buyer-favorable outcome is treating it as debt or leaving it in the business as cash at close; the most common is the buyer taking a margin haircut on it; the worst is the seller keeping the cash while the buyer still has to deliver the service.

The working capital true-up. The peg set during diligence and the true-up calculated at close must use the same method. If they do not, you manufacture a phantom adjustment that makes it look like the seller stripped the business when nothing actually changed. Consistency is the whole game.

Fees are scoped per deal and quoted as a fixed fee once we have seen the financials, so there is no hourly surprise and no scope creep. The factors that drive cost are deal size, buy-side vs. sell-side, the deliverable (data book vs. full report), the number of entities or locations, how clean the books are, and how complex the working-capital and deferred-revenue picture is.

Treewalk’s transactions team does Quality of Earnings work and nothing else, with a team that came up through the major accounting firms and brought that rigor down to the lower-middle-market. The reason it matters is repetition: a buyer might do one or two QoEs in a lifetime; we do dozens a year, so we know on sight what is a real add-back and what is not. Every engagement has a director scoping it and on the seller calls, a manager running it day to day, and an analyst doing the reconciliations.

A QoE is not just a safety check; it is a negotiating tool. It gives a buyer a documented, defensible reason to reopen price, restructure an earn-out, size a holdback, or set the working-capital target. Sellers respond to a clear schedule with the rationale attached far better than to a vague “the numbers feel high.”