Quality of earnings for first-time business buyers

What is a quality of earnings report on a small business?

A quality of earnings report is an accountant's review of whether the profit a seller is showing is profit a buyer can count on after the sale. People shorten it to QoE. On a small business it usually starts from seller's discretionary earnings or from EBITDA, then pulls out the pieces that will not repeat for you.

It is a different job from an audit. An audit tests whether the statements follow the accounting rules. A quality of earnings review asks a buyer's question: if I own this next year, what does a normal year actually earn? See SDE vs EBITDA for the two earnings numbers listings use.

The report does not set the price by itself. It gives you a cleaner earnings number. You and the seller still negotiate the multiple, and a CPA should walk through the adjustments with you before you write them into an offer. This is general education, not tax, accounting, or legal advice.

When does a small deal need a full quality of earnings report?

Pay for a full report when a wrong earnings number would cost more than the report, and use a lighter check when the books are simple and they tie out. A lighter check is you and your CPA reading the file. A full quality of earnings report is an outside accountant doing that work in a written scope, often with questions back to the seller.

• A lighter check fits a smaller, owner-operated business with a few years of tax returns, bank statements that match the revenue, and a short list of add-backs you can see on paper.
• A full report fits when add-backs are a large share of the profit, the books are accrual or messy, a big customer or a related company is in the numbers, or a lender has asked for an independent review.
• It also fits when the price is high enough that a 10 percent miss on earnings moves more money than the fee. There is no dollar cutoff that applies to every deal. Compare the fee to the mistake.

If you are still deciding whether the deal is worth a CPA at all, the business due diligence checklist is the wider pass. Earnings quality is one part of it.

What does a quality of earnings review adjust?

It adjusts profit so one-time items, the owner's personal costs, and accounting timing are not priced as if they will happen again for you. The adjustments people argue about on a small deal usually fall into a few piles.

• Owner add-backs. The owner's salary, personal expenses run through the business, and perks such as a car, travel, or a family member on payroll who does not work there. Each one needs a document. A round number with no invoice is a story, not an add-back.
• One-time items. A legal settlement, an insurance payout, a forgiven loan, a gain on selling a truck, or a repair that will not happen every year. One-time income should come out. A one-time expense can be added back if it truly will not repeat.
• Cash versus accrual. Many small businesses file taxes on the cash basis, so a big invoice paid in December can make that year look rich and the next year look poor. The review spreads revenue and expenses into the year they were earned, so one lucky collection does not become your purchase price.
• Related-party items. Rent paid to the owner's building, or a management fee paid to another company the owner controls, above or below what a stranger would charge. The normalized number uses a market rent, not the family rate.
• Working capital. Profit is not the cash sitting in the business. Receivables, inventory, and payables decide how much money has to stay in the company on day one. A quality of earnings review often flags that need. The closing mechanic is the working capital peg.

Customer concentration is an earnings-quality problem too. Profit that disappears when one account leaves is not a normal year. See customer concentration.

What are the red flags in a small-business earnings review?

The red flags are gaps between the seller's story, the tax return, and the bank account. Slow down, or walk, when you see these.

• Revenue on the profit and loss that the bank deposits cannot explain.
• Add-backs that are a large share of profit and have no invoices, cancelled checks, or payroll records.
• Expenses that fell sharply in the year being sold, especially repairs, advertising, or staff, with no change in how the business runs.
• A single month, a single customer, or a one-time job that creates most of the year's profit.
• Books on the cash basis with large unpaid bills the buyer will have to pay.
• Rent, payroll, or inventory moving between the seller's other companies with no written terms.
• Tax returns, internal statements, and the listing package that do not reconcile to each other.

A red flag is a question, not an automatic no. Ask for the document. If the document does not exist, take the adjustment out of the earnings before you talk about price.

What can a buyer check before paying for a report?

You can test the seller's earnings number yourself from the tax return, the bank statements, and a written add-back list, and that pass tells you whether a full report is worth buying. Do it in this order, and write down every gap.

1. 1
   Start from the filed tax return

   Use the return the seller sent the government, not the spreadsheet in the listing. Read the last three years if you can get them.

2. 2
   Tie revenue to the bank

   Add up deposits for the same year and ask the seller to explain anything that is not customer revenue: loans, transfers from another account, tax refunds.

3. 3
   Test each add-back

   Put every personal expense and one-time item on one list. Ask for the invoice or the payroll record behind each line. Drop the ones with no paper.

4. 4
   Mark cash or accrual

   Ask which basis the books and the return use. If a large invoice or a large bill sits in a different year from the work, note it before you treat that year as normal.

5. 5
   List who the profit depends on

   Customers, the owner, and any related company. A profit that needs all three to stay put is a different deal from a profit with a wide customer list.

6. 6
   Then call a CPA

   Show them the gaps. They can tell you whether a lighter review is enough or whether you should hire a firm for a full quality of earnings report before you raise the price.

While you read the books, check the company itself on the public record. Run a BizFacts report for registration, liens, litigation, bankruptcies, tax standing, and watchlist hits. BizFacts is a record search. It does not verify revenue, confirm profit, or replace a quality of earnings review.

After you have an earnings number you are willing to use, see whether the price works with little of your own money. See my $0-down plan. DealBrain structures the deal so you put in little or $0 of your own money, and walks you through every step to closing. We find the money for you. It is for anyone buying a business. Free first look. No credit check. $299 per deal, one time, only if you keep going. Not a subscription. Estimates only. Not a loan offer, and not legal, tax, or financial advice.

What does a quality of earnings report cost?

A lighter CPA review of a straightforward small business is often a few thousand dollars, and a full report on a larger or messier company often costs more, sometimes into the tens of thousands. Treat that as a typical range people quote, not a price for your deal. The fee moves with the size of the business, how many years you want read, how messy the records are, and who you hire.

Ask two firms what they will actually do, and for a written fee, before you hire one. A cheap letter that restates the seller's add-backs is not the same product as a report that ties the bank account to the tax return. Who pays, buyer or seller, is a negotiation. Many buyers pay because they are the ones who need to trust the number.

Have your CPA and, before you sign, your attorney read anything you will rely on. A quality of earnings report is not a guarantee that next year will match, and it is not a promise that a lender will accept the adjustments.