A sophisticated private equity buyer is using a regression-based model to analyze our historical financial data. What diagnostic checks are they running on our trailing twelve months EBITDA, and how do we prepare?

Question

Tyler Smith · Accepted Answer

Sophisticated private equity (PE) buyers conduct rigorous diagnostic checks on your trailing twelve months (TTM) EBITDA to ensure your financial reporting is robust, compliant, and reflective of a stable business. They are looking for predictability, stability, and any potential red flags that might impact future cash flows or valuation.

Diagnostic Checks on TTM EBITDA

PE buyers will typically focus on the following areas:

• Financial Reporting Robustness: They want to confirm that your financial statements are accurate, complete, and prepared according to standard accounting principles. This often involves ensuring your books are audit-ready.
• Normalization Adjustments: Buyers will scrutinize your EBITDA for any non-recurring or non-operational items. This includes:
• Nonrecurring expenses: One-time costs that won't be repeated in the future.
• Owner compensation adjustments: Ensuring owner salaries and benefits are at market rates.
• Personal expenses: Any personal expenses of the owner or executives run through the business.
 The goal is to arrive at a normalized EBITDA that reflects the true operating performance of the business.
• Revenue Recognition Inconsistencies: They will look for any unusual patterns or practices in how you recognize revenue, which could inflate current period results or mask future risks.
• Abnormal Working Capital Swings: Significant fluctuations in working capital (e.g., inventory, accounts receivable, accounts payable) can indicate underlying operational issues or cash flow instability.
• Multicollinearity and Volatility: In their regression-based models, buyers will assess the relationships between different financial variables.
• Multicollinearity refers to situations where independent variables in the model are highly correlated, which can make the model less reliable.
• Volatility in revenue streams or other key metrics signals higher risk regarding future performance and cash flow predictability.

How to Prepare for Scrutiny

To prepare for this level of scrutiny, your finance department should:

• Maintain Clean, Audit-Ready Financials: This is fundamental. Ensure your financial records are meticulously organized, reconciled, and capable of withstanding a thorough audit.
• Document Normalization Adjustments: Proactively identify and document all nonrecurring expenses, owner compensation adjustments, and personal expenses. Be prepared to explain and provide evidence for each adjustment.
• Demonstrate Disciplined Financial Processes: Show how your business operates with financial discipline. This includes:
• Tracking scorecard metrics and [key performance indicators](/qa/thinking-time-accountability-chart-bottlenecks) (KPIs).
• Regularly reviewing these metrics with your leadership team.
• Highlighting how your [Accountability Chart](/qa/exit-readiness-accountability-chart-seat) clearly defines who is responsible for financial performance.
• Proactively Address Red Flags: If you are aware of any potential inconsistencies or volatile areas, have a clear explanation and, ideally, a plan to mitigate them. Transparency builds trust.
• Leverage Data: Be ready to provide comprehensive data that supports your financial narrative. This includes historical financial statements, detailed general ledgers, and supporting documentation for all significant transactions. This level of preparation will enable you to confidently address the buyer's diagnostic checks and defend your [enterprise value](/qa/replaceable-visionary-seat-exit-readiness).