Most acquisition prices are built on earnings. So the most important question in any deal is simple: are the earnings real?
The core questions
- Are the reported numbers accurate?
- Are the add-backs legitimate? See seller’s discretionary earnings.
- Will the earnings continue? Customer stability, contracts, market trends.
- Will they continue without the seller? Owner dependence is a financial risk.
- What does the business need to operate? Working capital and capital spending.
Step 1: Tie the documents together
- Tax returns to financial statements. Differences need explanations.
- Financial statements to the general ledger.
- Revenue to bank deposits — often called a proof of cash. Buyers and lenders rely on what can be verified.
If income isn’t on the books, buyers and lenders generally won’t pay for it. Unreported income also creates legal exposure for the seller.
Step 2: Scrutinize add-backs
Add-backs adjust earnings for expenses that won’t continue under a new owner: the owner’s salary and benefits, one-time costs, personal expenses run through the business. Legitimate add-backs are documented. Aggressive ones — “we’ll lose that customer’s discount next year,” “my nephew doesn’t really work here” without evidence — get challenged.
Test each add-back: Is it documented? Is it truly non-recurring or personal? Will the buyer actually avoid it? Does a replacement manager need to be paid in place of the owner?
Step 3: Analyze revenue quality
- Customer concentration. How much depends on a few customers?
- Recurring vs one-time revenue. Contracts and repeat customers are more valuable.
- Trends. Monthly revenue over several years, by customer and service line.
- Pricing. Recent price changes and how customers responded.
- Backlog and pipeline, where relevant.
Step 4: Analyze margins and costs
Gross margins by service or product, labor costs and overtime, vendor price changes, and costs the seller may have deferred — maintenance, hiring, technology — to make recent earnings look better.
Step 5: Working capital
Receivables, inventory and payables — the cash tied up in running the business. Buyers want enough working capital delivered at closing to run normally. Look at aging of receivables, slow-moving inventory and stretched payables. See working capital in an acquisition.
Step 6: Debt and liabilities
Loans, equipment financing, leases, credit lines, deferred revenue, customer deposits, unpaid taxes and accrued payroll. In an asset sale, most debts stay with the seller, but you still want to know what liens exist and how they’ll be released at closing.
Step 7: Capital expenditures
What will it take to keep equipment, vehicles, facilities and systems running? A business with old equipment may need significant investment soon after closing — a real cost to the buyer.
Quality of earnings reports
For larger deals, or when lenders or investors require it, buyers often hire an accounting firm for a quality of earnings analysis. It’s an independent view of earnings, adjustments and working capital. For smaller deals, a buyer’s CPA may perform a narrower scope review. Either way, the buyer should understand the findings personally, not just file the report.
Sellers: get ahead of it
Some sellers commission their own quality of earnings work before going to market. It surfaces issues early, supports price and speeds diligence. At minimum, sellers should reconcile tax returns and statements, document every add-back and clean up personal expenses. See prepare a business for sale.
What lenders look for
If an SBA or bank loan is involved, the lender will run its own analysis: historical cash flow, debt coverage, the buyer’s experience and personal finances, collateral and a business valuation. The lender’s view can affect the price and structure that’s financeable. See SBA loan to buy a business.
Common findings and what they mean
| Finding | Likely impact |
|---|---|
| Earnings lower than presented | Price adjustment or walk away |
| Heavy customer concentration | Earnout, seller financing or lower price |
| Unsupported add-backs | Earnings re-stated |
| Deferred maintenance | Price adjustment or seller fix before closing |
| Weak receivables | Working capital adjustment |
A buyer’s mindset
Good financial diligence isn’t about catching the seller in a lie. Most sellers aren’t lying; their books were built for taxes and management, not for buyers. The buyer’s job is to translate those books into a clear view of what the business really earns and what it needs. When I do this, I share my questions openly, because sellers usually have good answers when they’re asked directly.
Monthly, not just annual
Annual numbers hide a lot. Ask for monthly statements over several years and lay them side by side. Seasonality, a lost customer, a price increase, a new hire, a big one-time job — they all show up in monthly patterns that disappear in annual totals. Monthly data also lets you compare the most recent months to the same months last year, which is the clearest read on current momentum heading into closing.
Next steps
Continue to legal due diligence or back to the due diligence guide. Questions about a specific deal in South Carolina? Talk to Ben about acquisitions.
Questions people ask
What is a quality of earnings report?
A quality of earnings (QoE) report is an independent analysis, usually by an accounting firm, that tests a business’s reported earnings — verifying revenue and expenses, scrutinizing add-backs and adjustments, and analyzing working capital — to establish earnings a buyer can rely on.
What financial documents should a buyer request?
Several years of tax returns and financial statements, recent interim statements, bank statements, general ledger, accounts receivable and payable agings, payroll records, customer and vendor reports, debt schedules and documentation for every add-back.