What a quality-of-earnings analysis actually proves

A quality-of-earnings analysis is one of the most misunderstood steps in a deal. Buyers new to the lower-middle market often assume it is a kind of mini-audit, or that a clean set of reviewed financials makes it unnecessary. Neither is true. An audit asks whether the financial statements conform to accounting standards. A quality-of-earnings analysis asks a different and more useful question: of the earnings this business reports, how much can a new owner actually count on next year?

That gap, between reported EBITDA and sustainable EBITDA, is where deals are won, lost, and re-priced.

Adjusted EBITDA is an argument, not a fact

Every seller arrives with an adjusted EBITDA number, and every adjusted EBITDA number is really a stack of arguments. The owner's compensation gets normalized to a market salary. One-time legal expenses get added back. A discontinued product line gets stripped out. Some of these adjustments are obviously fair. Others are aggressive, and a few are simply wrong.

The work is to test each one. Is the owner's replacement salary realistic for the role, or is it set low to inflate the add-back? Was that "one-time" expense actually the third one-time expense in three years, which makes it recurring? Did the add-back for a closed location quietly leave the revenue in while taking the cost out? A senior reviewer who has seen hundreds of these knows where the soft spots usually are, and goes straight to them.

Working capital is where value quietly moves

Most first-time buyers underweight working capital, and most sophisticated sellers do not. The working-capital target set at close determines whether the buyer or the seller funds the cash the business needs to operate on day one. A target set a few hundred thousand dollars too high, or a methodology that cherry-picks favorable months, transfers real money at closing without ever touching the headline price.

A proper analysis builds the working-capital picture from the bottom up: the true monthly trend, the seasonality, the one-off swings that should be excluded, and a defensible target that both sides can stand behind. This is unglamorous work. It is also where a diligence fee pays for itself several times over.

Proof of cash ties the story to reality

Reported revenue is a story. Cash in the bank is what happened. Proof of cash reconciles the two, matching bank deposits to recorded revenue over a representative period, and it is one of the fastest ways to catch a number that does not hold together. When revenue recognition is aggressive, when there are related-party flows that inflate the top line, or when the books have simply drifted from reality, proof of cash is where it surfaces.

Why this matters more, not less, below $25M of EBITDA

In the lower-middle market, the businesses are often owner-operated, the financial function is thin, and the books were built to run the company and minimize taxes, not to be sold. That is not a knock on the seller. It is the normal condition of a good business that has never been through a transaction. It also means the distance between reported and sustainable earnings tends to be wider, and the documentation behind the add-backs tends to be thinner.

That is precisely the environment where senior judgment earns its keep, and precisely the environment the national firms are least interested in staffing well. A real quality-of-earnings analysis at this end of the market is not a checkbox. It is the difference between buying the business you think you are buying and finding out the hard way that you did not.

If you are weighing an acquisition and want the real number before you commit, start a conversation.