Quality of Earnings and EBITDA add-backs.

A Quality of Earnings analysis is used to set and defend purchase price. Because valuation is a multiple of adjusted EBITDA, the QoE determines the number that multiple applies to.

It serves three audiences with different needs. Buyers use it to test seller claims and support negotiation. Lenders and private credit funds require it to size debt against sustainable cash flow. Investment committees treat it as the analytical basis for approval. Sellers increasingly commission sell-side QoE reports before going to market, to pre-empt buyer adjustments and protect valuation.

An EBITDA add-back is an expense added back to reported earnings because it is non-recurring, non-operational, or will not continue after the transaction closes. Add-backs raise adjusted EBITDA and therefore raise valuation.

Owner compensation is the standard example. A founder paying themselves $500,000 in a business that would pay a professional manager $200,000 creates a $300,000 add-back, because that excess cost disappears under new ownership. The logic is forward-looking, which is the source of most disputes: an add-back is valid only if the buyer genuinely will not incur the cost. Add-backs are the most contested element of most lower middle market negotiations.

The most common are owner compensation normalization, personal expenses run through the business, non-recurring professional fees, one-time legal settlements, and rent adjusted to market rate on related-party property.

Others that appear regularly:

• Non-recurring severance or restructuring costs
• Discontinued product lines or closed locations
• Above or below market salaries paid to family members
• Transaction costs from the current sale process
• Accounting basis corrections, including cash to accrual conversion errors
• Deferred maintenance or capital expenditure misclassified as operating expense
• Insurance proceeds, litigation recoveries, or government subsidies
• Inventory and reserve adjustments that belonged to earlier periods

Add-backs are identified by reviewing general ledger transaction detail, not summary financial statements. Analysts examine individual entries, vendor names, account classifications, posting dates, and manual journal entries to isolate costs that are non-recurring or unrelated to ongoing operations.

The working process is: obtain the full general ledger, foot it to the trial balance, scan for unfamiliar vendors and round-number entries, test expense accounts with high period-over-period variance, review manual and reversing entries, then cross-reference candidates against bank records and invoices.

Sellers usually arrive with a prepared add-back schedule. That schedule is a hypothesis to be tested against the ledger. It is not evidence.

A legitimate add-back is traceable in the general ledger, documented, and genuinely will not recur under new ownership. All three conditions have to hold, and most disputed add-backs fail on the second.

The five tests a buyer should apply to every line:

• Traceable. The item ties to specific journal entries and a specific amount, not to a management estimate.
• Documented. An invoice, contract, settlement agreement, or payroll record supports it.
• Non-recurring in fact. The item appears in one period only, rather than reappearing in a different form every year.
• Not operationally required. The business can run without the cost after close.
• Consistently treated. The same category of expense is handled the same way across all periods presented.

An add-back that fails the documentation test is an assertion. An add-back that fails the non-recurrence test is usually a normal operating cost that has been relabeled.

An aggressive add-back adds back a cost that is actually recurring, is unsupported by documentation, or was never incurred at all. The most aggressive versions add hypothetical income rather than removing real expense.

The recurring patterns:

• The recurring one-time item. A one-time legal expense that appears in all three years presented.
• Pro forma revenue. Projected sales from a new product, or a contract signed but not yet started.
• Unrealized synergies. Cost savings or headcount reductions that have not been executed.
• Run-rating. Annualizing the strongest quarter and presenting it as the baseline.
• Undocumented owner perks. Personal expenses claimed without any transaction support.
• Capitalization shifts. Moving ordinary operating expense onto the balance sheet.
• Macro normalization. Unquantified adjustments for a bad year attributed to external conditions.

The reliable test is documentation. Legitimate add-backs come with support. Aggressive add-backs come with explanation.

Each adjustment is mapped to the specific general ledger accounts and journal entries that produced it, with amounts by period. Those account totals must foot to the trial balance, and the trial balance must tie to the financial statements.

The deliverable is a bridge. It starts from reported net income or reported EBITDA, lists each adjustment as a separate line carrying a general ledger reference, and arrives at adjusted EBITDA. Every line should be traceable in one step to the entries beneath it. An adjustment that cannot be tied to a specific account and period is an estimate, and the report should label it that way. Unreconciled adjustments are the first thing an experienced lender or investment committee challenges.

Because add-backs exist at transaction level and financial statements only show totals. A profit and loss statement showing $1.2 million in professional fees does not reveal whether that is recurring accounting work or a single litigation matter.

Only the general ledger shows individual entries, vendor detail, posting dates, manual journal entries, and account classification. That detail is what separates a supportable adjustment from an assumption. It also exposes problems invisible in summary form: entries posted after period close, reversing entries, intercompany transfers, and expenses recorded in the wrong period.

A QoE built only on financial statements can restate what management reported. It cannot independently test it.