What is a Quality of Earnings (QoE) analysis?

A Quality of Earnings (QoE) analysis is a financial due diligence procedure that adjusts a target company's reported EBITDA to reflect its true run-rate earnings. It identifies one-time items (that inflate reported EBITDA) and persistent expenses that should be normalized (like below-market owner compensation). The adjusted EBITDA becomes the basis for purchase price negotiations. QoE typically identifies both seller add-backs (items that overstate EBITDA, reducing the buyer's offer) and buyer add-backs (items that understate EBITDA, increasing the buyer's offer). The net result is negotiated EBITDA used in the pricing multiple.

What is a working capital peg in M&A?

A working capital peg (target working capital) is a negotiated amount of working capital that should be in the business at closing. If actual closing working capital exceeds the peg, the buyer pays more (excess is treated as a price increase). If closing working capital is below the peg, the seller pays the buyer the shortfall (post-closing adjustment). The peg is typically set at the trailing 12-month average working capital to represent 'normal' operating working capital — ensuring the buyer gets a fully operational business, not one stripped of working capital.

AI for Financial Due Diligence Checklist: M&A Quality of Earnings and FDD with Claude (2026)

How M&A advisors use Claude AI for financial due diligence: quality of earnings analysis (normalized EBITDA bridge), one-time item identification and quantification, net debt and debt-like item computation, working capital peg analysis, and FDD risk finding documentation.

Financial Due Diligence and AI

Financial due diligence (FDD) in M&A is a systematic investigation of a target's financial statements to verify the quality of reported earnings, identify risks, and establish the true normalized EBITDA for deal pricing. A full FDD report — quality of earnings, net debt analysis, working capital analysis, and financial risk identification — typically takes 4-6 weeks for a team of 3-4 advisors. Claude with ClaudeFinLab structures the analysis, flags items requiring investigation, and drafts sections of the FDD report.

Quality of Earnings Analysis

"Perform quality of earnings analysis for this acquisition target: reported LTM EBITDA $22.4M. Identify and quantify potential adjustments: (1) One-time revenue items: $1.2M government COVID relief grant (non-recurring, remove from revenue) → EBITDA -$1.2M; (2) Seller add-back claimed: $0.8M restructuring charges (verify documentation — if one-time, add back; if recurring, reject); (3) Below-market CEO salary: CEO pays himself $220K vs market $450K for this role/size — normalize to market: +$230K expense → EBITDA -$230K; (4) Personal expenses in SGA: $145K in owner personal travel/meals charged to company → remove to adjust to normalized operating SGA; (5) Revenue pull-forward: $0.6M of Q4 software revenue recognized early (aggressive), likely to reverse. Adjusted EBITDA: $22.4M - $1.2M + $0.8M - $230K + $145K - $600K = $21.3M."
"Build the normalized EBITDA bridge from reported to adjusted: starting from reported EBITDA $22.4M, list each QoE adjustment with: (1) item description; (2) amount (positive = increases normalized EBITDA, negative = decreases); (3) category (one-time revenue, one-time expense, non-recurring, normalization); (4) buyer's view vs seller's view (buyers often dispute seller add-backs, sellers challenge buyer adjustments). Final agreed normalized EBITDA = basis for purchase price at negotiated multiple. Draft the summary QoE adjustment table for the FDD report."

Net Debt Analysis

"Compute net debt for purchase price adjustment: gross debt: senior notes $45M, revolver $8M drawn, equipment financing $3.2M, deferred financing costs -$0.8M = total debt $55.4M. Cash and equivalents: $4.2M (restricted cash $0.8M excluded — held for bond covenant compliance). Net debt = $55.4M - $4.2M = $51.2M. Debt-like items to include: (1) unfunded pension obligation $2.1M (PBO in excess of plan assets); (2) earnout liabilities $1.5M; (3) operating lease obligations (ASC 842) $3.8M; (4) accrued but unpaid bonus $0.6M (owed to employees). Total debt-like: $8.0M. Adjusted net debt: $51.2M + $8.0M = $59.2M. Equity purchase price = enterprise value - adjusted net debt."

Working Capital Analysis

"Compute the working capital peg: trailing 13 months of working capital data (paste monthly AR, inventory, prepaid, AP, accrued liabilities). Target working capital (peg) = 13-month simple average. Exclude: (1) cash (not in working capital peg); (2) short-term debt and current portion of long-term debt; (3) accrued M&A transaction costs (excluded as they close with the deal); (4) deferred revenue (seller argument: this is a liability the buyer inherits; buyer argument: it's an offset to future revenue). Compute the peg. If closing working capital is $12.4M vs peg $11.8M: buyer pays seller an additional $0.6M post-closing. Draft the working capital section of the FDD report."

Financial Risk Identification

"Identify financial risks from the data room review: (1) Revenue concentration: top 3 customers = 58% of revenue ($12.8M). Largest customer: 22% ($4.8M). If customer 1 is lost post-close: EBITDA impact -$4.8M × 70% margin = -$3.4M (vs normalized EBITDA $21.3M = 16% decline). Risk: HIGH. Mitigation: MAC clause tied to customer retention; customer specific escrow. (2) Accounts receivable quality: AR days 72 (vs prior year 54 days) — concerning increase. Investigation needed: are collections slowing or was revenue pulled forward? (3) IP ownership: 2 key patents developed by a contractor in 2019 — verify IP assignment agreement. (4) Tax risk: 3-year tax assessment open in Texas ($420K potential liability). Draft risk summary for the preliminary findings memo."

Where to Start

For a buy-side FDD engagement, start with the QoE adjustment table. Ask Claude to help identify and structure the common adjustment categories — one-time items, normalizations, seller add-backs, and buyer adjustments — for the specific target's industry. Then compute net debt, including all debt-like items that reduce equity value. These two outputs (normalized EBITDA and adjusted net debt) are the core of the purchase price negotiation and represent 80% of the financial due diligence value.

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