Quality of Earnings Adjustments: Common EBITDA Add-Backs and Which Hold Up
Short answer: Quality of earnings adjustments are the changes a diligence team makes to reported EBITDA so it reflects recurring, arm’s-length operations. They fall into four groups: non-recurring items, owner-related items, accounting corrections, and pro forma adjustments. The ones that hold up are documented and traceable to the bank; the ones that get cut are recurring costs labeled as one-time and projections presented as history.
For independent sponsors, search funds and private equity buyers, the adjusted EBITDA figure sets the price and the debt capacity. For sellers and their bankers, it is the number that has to survive the buyer’s diligence. Both sides are looking at the same schedule.
The four groups of adjustments
| Group | Typical examples | Evidence that holds up |
|---|---|---|
| Non-recurring | Litigation settlements, one-time consulting projects, relocation costs, insurance recoveries | Invoices and agreements showing a single event, and a multi-year history showing it did not recur |
| Owner-related | Owner compensation above or below market, personal expenses paid by the business, related-party rent | Payroll records, a market compensation benchmark, bank and card detail for personal items, a market rent estimate |
| Accounting corrections | Cash-to-accrual conversion, cutoff errors, misclassified costs, inventory adjustments | Reconciliation of the books to bank activity and to the tax return, with the entries that correct them |
| Pro forma | Full-year effect of price increases, new contracts, cost savings, headcount changes | Signed contracts and executed changes. Projected savings rarely survive. |
Add-backs that rarely survive diligence
- Recurring “one-time” costs. A legal bill that shows up every year is a cost of doing business. Three years of history is usually enough to tell.
- Undocumented personal expenses. A round-number add-back for “owner personal expenses” without transaction detail is the first thing a buyer’s diligence team cuts.
- Owner compensation set at zero. Removing the owner’s salary without adding back the cost of replacing their role overstates earnings.
- Synergies and run-rate savings. Savings the buyer might achieve belong in the buyer’s model, not in the seller’s historical EBITDA.
- Revenue that never reached the bank. If reported revenue does not tie to deposits, every adjustment built on it is moot.
Why the proof of cash comes first
Adjustments are made to reported earnings, so they inherit any error in them. A proof of cash reconciles bank deposits and disbursements to reported revenue and expenses before anyone argues about add-backs. It also does much of the adjustment work: personal expenses show up in the disbursement detail, misclassified costs show up as mismatches, and revenue that never arrived shows up as a gap.
Adjustments in SBA-financed deals
For SBA 7(a) Initial Acquisitions and Business Expansions with a purchase price of $3 million or more, SOP 50 10 8.1 requires the quality of earnings report to identify and document all add-backs, naming non-recurring items, above- or below-market owner compensation, related-party transactions, deferred maintenance, and cash-basis versus accrual-basis differences. The lender must then use the QoE earnings, not the seller’s adjusted figure, to calculate debt service coverage. Add-backs that do not survive reduce the supportable loan. See SBA quality of earnings for the full rule.
How QoEAgent builds the adjusted EBITDA schedule
QoE Essentials, our full quality of earnings engagement, produces the normalized EBITDA schedule with every adjustment documented and traced to the bank statement line and general ledger entry behind it. It sits on top of our proof of cash, returned within 24 hours of data ingestion, and GAAP-formatted financial statements, returned within 48. See the quality of earnings checklist, what a sell-side quality of earnings does, and quality of earnings report cost.