Quality of Earnings on Small Deals

A quality of earnings review is now mandatory on SBA-financed acquisitions of $3 million or more, and it is worth considering on many smaller ones. The review answers the question on which the entire price depends: are the earnings the seller has presented accurate, and are they likely to continue? For a buyer about to sign a personal guarantee, a few weeks and a modest fee spent on that question is usually money well spent.

What it is, and what it is not

A quality of earnings analysis, commonly called a QoE, is an examination of a company's historical earnings by an independent accounting professional. Its focus is the sustainability and accuracy of cash flow.

It differs from an audit. An audit expresses an opinion on whether financial statements conform to accounting standards. A QoE is concerned with economic reality: what the business actually earns, on a normalized basis, and how reliably. Many small companies have never been audited, and a QoE does not require that they have been.

What the review covers

The scope varies with deal size, but most reviews address the following.

Proof of cash. Deposits and disbursements on the bank statements are reconciled to revenue and expenses on the income statement and to the tax returns. This is the most direct test of whether reported revenue was received.

Revenue analysis. Sales are examined by customer, product and month. The review looks at concentration, trends, seasonality, pricing changes and whether revenue was recorded in the correct period.

Normalization of earnings. Each proposed add-back is tested against supporting documents. The reviewer also identifies adjustments the seller did not propose, such as below-market owner compensation or one-time income.

Margins and costs. Changes in gross margin and operating expenses are explained. Costs that have been deferred or understated are identified.

Working capital. Monthly balances of receivables, inventory and payables are analyzed to establish a normal level, which informs the working capital target in the purchase agreement.

Debt and debt-like items. The review lists obligations a buyer may inherit: customer deposits, deferred revenue, accrued vacation, unpaid taxes and equipment leases.

The product is a report showing reported earnings, each adjustment, and a normalized figure for each period reviewed.

When SBA rules require one

Under the SBA's rules for loans numbered on or after October 1, 2026, a QoE is required for initial acquisitions and business expansions when the purchase price of the business, excluding owner-occupied real estate, is $3 million or more. Owner buyouts and ESOP transactions are exempt.

Several features of the requirement are worth noting.

• The report must be prepared by an independent, experienced financial professional for the benefit of the lender. A report prepared by or for the seller does not satisfy it.
• It must include a proof of cash covering the trailing twelve months and the two most recent fiscal years.
• The lender must use the report's normalized earnings in calculating debt service coverage.

That last point has direct consequences for price. If the report supports lower earnings than the seller presented, the loan the business can carry is reduced accordingly. Buyers should confirm with their lender how the provider will be engaged, since guidance on buyer-commissioned reports has continued to develop.

Below the threshold

Most Main Street acquisitions fall under $3 million, where the review is optional. A full-scope QoE may cost more than a small transaction justifies, but the underlying work can be scaled.

On a transaction of $500,000 to $1 million, a limited engagement might include a proof of cash for twenty-four months, verification of the principal add-backs, and a review of revenue by customer. This costs a fraction of a full report and addresses the risks that matter most.

A scaled review is particularly worthwhile in certain conditions.

• A large share of earnings comes from add-backs.
• The business handles significant cash.
• Financial statements are prepared internally with no outside accountant.
• Revenue has grown sharply in the most recent year.
• The buyer has no prior experience in the industry.
• The statements and tax returns differ and the explanation is incomplete.

What reviews commonly find

Certain findings recur.

• Add-backs that lack documentation or that represent ongoing costs
• Revenue recorded before it was earned, or customer deposits treated as sales
• A one-time project or customer that inflated the most recent year
• Expenses paid personally by the owner and missing from the books
• Owner or family compensation below what a replacement would cost
• Deferred maintenance or delayed hiring that temporarily raised profit
• Inventory or receivables carried at more than they are worth

Not every finding reduces value. Reviews sometimes identify expenses that were overstated or legitimate adjustments the seller overlooked.

How buyers use the results

A buyer has several possible responses. If the findings confirm the seller's figures, the buyer proceeds with greater confidence, and so does the lender. If normalized earnings are lower, the buyer may seek a reduced price, a larger seller note, or specific protections in the purchase agreement. If the findings reveal that records are unreliable, the buyer may withdraw. Each outcome is preferable to learning the same facts after closing.

The sell-side version

A seller may commission a review before going to market. This allows the seller to find and address problems in advance, present adjustments that have already been tested, and shorten the buyer's diligence. On transactions that will require a lender's QoE, a sell-side report does not replace it, but it greatly reduces the likelihood of an unwelcome result.

Practical guidance

1. Raise the subject in the letter of intent. State that the buyer will conduct financial diligence, including a QoE where applicable, and allow time for it.
2. Engage a provider with experience in transactions of similar size. Scope and cost should be proportionate.
3. Begin immediately after the LOI is signed. Three to four weeks is typical once documents are provided.
4. Ask the seller for bank statements early. Proof of cash cannot be done without them.
5. Share the results with the lender promptly.

The earnings figure drives the price, the loan and the buyer's return. Verifying it independently is the most direct way to confirm that all three rest on something sound.

Twelve31 Advisors coordinates financial diligence for acquirers and helps sellers prepare for it.