What a Quality of Earnings Report Won't Tell You

A clean report proves the profit was real last year. It can't prove it survives the day you take over. The gap between the two, and how to read it before you wire the money.

A buyer I know closed on a good services business, about two and a half million in revenue. Clean books. A quality of earnings report that tied out to the penny. Real profit, roughly what the seller said it was. He wired the money and felt smart doing it.

Six months later the biggest customer left. Turned out that account wasn't loyal to the business. It was loyal to the guy who just cashed out. Close to forty percent of the revenue walked out the door with a handshake, and none of it showed up as a problem in diligence. The report was right. The profit was real. It just wasn't his anymore.

Here's the quick and dirty version, and it's the whole point of this piece. A quality of earnings report tells you the profit was real last year. It cannot tell you whether that profit survives the day you take over. Those are two different questions. A QoE answers the first one well. I'm biased, it's work we do, but I'd want one on any deal I was serious about. It was just never built to answer the second question, and on a small acquisition that second one is what bankrupts people. If you're buying a business, you need to know exactly where the report stops and where you're on your own.

I've sat on both sides of this. I came up in finance reading numbers for a living, then spent years operating businesses and watched buyers price some of them. The numbers matter. But a number is the result of a business, not the business itself. First, what a good report actually checks. Then the part nobody hands you.

What a quality of earnings report actually checks

A QoE is not an audit and not a valuation. It's a buyer's financial review with one job: figure out what the business really earns, stripped of the owner's personal noise. A good one checks five things.

1. The tax return. A disciplined review doesn't take the seller's slick P&L at face value. It rebuilds the earnings from the books and ties them back to the filed return, the one number the seller signed.
2. The add-backs. Every adjustment the seller made to dress up profit, tested one by one.
3. Proof of cash. Reconciling reported revenue to what actually hit the bank, month by month. Bank statements are far harder to dress up than a P&L, though not impossible, which is exactly why you tie the story back to them.
4. The payroll. The register, the books, and the quarterly filings all have to agree.
5. Revenue durability. How much of this repeats, versus how much was one good year.

Get those five right and you know what the business earned. That's real work, and it's worth paying for. But all five look backward, and they look at paper.

What a quality of earnings report won't tell you

This is where buyers get hurt, and it isn't a knock on the report. The report is clean, so they stop looking. And a good report will flag a lot of what follows. What it can't do is resolve it, because resolving it means calling the customers and walking the shop floor, and that's not the engagement. A cheap checkbox review skips even the flagging. Either way, this part is on you.

Proof of cash proves the money existed, not that it was booked right. A cash proof ties the totals. By itself it won't catch a marketing cost buried in payroll, or an owner expense parked in cost of goods. The totals reconcile and the margins can still be wrong. Sorting the classifications is a separate test, and it's worth insisting on.

Concentration is an earnings-quality question, not a footnote. The report shows you one customer is thirty percent of revenue. It can't tell you whether that revenue survives one phone call, or whether the relationship belongs to the seller instead of the business. And the part that burns buyers after close: you can create concentration by winning. Land a big new account and that one relationship is suddenly a third of the business, a risk you built yourself by succeeding. You can also buy back a customer's loyalty by cutting price, so a clean retention number can hide a margin you're about to give away. Tie durability to gross margin and to whether the relationship actually transfers, or you're guessing.

It can't tell you if the business runs without the seller. This is the whole game on a small deal. A good report will flag that the business leans on the owner. What it can't do is find out whether the top customers trust anyone but him. If the seller is the top salesperson, the master estimator, and the only name the big accounts know, you didn't buy a business, you bought a job with the seller's face on it. "I'll introduce you after we sign" is not a transition plan. Neither is a personal license or certification that leaves with him: in a lot of trades, the day he walks you can't legally pull a permit, and the sale memo never mentions it.

A pile of add-backs on a business starving itself is a trap. If the profit number everyone quotes looks great because the seller quit spending on trucks, equipment, and maintenance, you're not buying profit, you're buying deferred bills. The report normalizes earnings, meaning it adjusts them to a clean, typical year. It doesn't tell you the roof is done in two years.

Working capital can quietly become your problem on day one. A QoE will show you the working-capital swing, the cash the business needs tied up in receivables and inventory just to run, and how it moves with the season. What it won't do is stop you from glossing over what that swing means for your own pocket. The peg, the amount you're required to leave in the business at close, is usually set off a trailing average. Ask which months are in that average and whether it quietly captures your busy season instead of your slow one. And on an SBA loan you often can't go back and fix the number after closing (true it up) the way a bigger deal can, so if you guess low, you fund the gap yourself. Get this wrong and you've spent cash you didn't plan to spend before you've made a single decision.

And the report won't get you financed. This one surprises people. On an SBA-sized deal, your lender underwrites the tax returns and the debt service, whether the profit covers the loan payments, not your analysis. A clean report can sit right on top of a deal the bank still won't fund. That's a separate question, and you have to ask it out loud early.

None of that lives in the workpapers. All of it is the difference between a buyer who sleeps and a buyer who's up at 2am.

Add-backs are claims, not facts

Add-backs are where the real money moves, so they get their own rule. On a deal this size you're usually buying seller's discretionary earnings, SDE, not the EBITDA the big deals talk about, and the single biggest line in it is what the owner paid himself. Every add-back on top of that is a claim the seller is making, and the burden of proof is on them, not you. Make each one pass a three-part test: a source document, a plain reason it won't happen again, and a benchmark that it's above market. No receipt, no reason, no benchmark, it comes out of the price.

The math isn't small. A small business is often priced at around four times its earnings, so every dollar you let the seller add back is worth about four dollars in price. Strip one unsupported eighty-five-thousand-dollar add-back and the price just dropped over three hundred thousand. The brightest light is owner pay. The question is never what the seller paid himself. It's what a hired manager costs to do his job at market, and that number goes back into the earnings whether the seller likes it or not. When the add-back schedule runs longer than the profit, that length is itself the tell.

My partner Ryan, a CPA who's done well over a hundred of these from the buyer's side, puts it simply: an add-back has to make the number honest, not just bigger. If you can't hand him the receipt and a reason it won't repeat, it isn't an add-back, it's a wish. He goes deeper on the financial mechanics in his own writing on add-backs. I'm here for the part that isn't on the spreadsheet.

What a quality of earnings report costs, and what it's worth

For a small acquisition, a focused review runs a few weeks and a fixed fee that scales with how messy the books and the deal are. It's usually a low single-digit slice of the purchase price, less than a month of the loan payments you're about to sign up for. I won't put a sticker on it, but that's the order of magnitude.

Now the trade. A buyer I traded notes with skipped the review on a clean-looking deal, around four and a half million, and later found close to two hundred thousand a year in recurring costs the seller had been quietly capitalizing, treating everyday expenses as one-time investments so they never hit the profit line. At the multiple he paid, that mispriced the business by the better part of a million, discovered six months too late. The fee would have been a rounding error against it. The way searchers put it on the deal forums: a quality of earnings report is insurance, and the one time you skip it is the one time you needed it.

None of that means skip the report. It means don't stop at it. A good QoE is the strongest read you can buy on the numbers, and you want it. It just isn't a fraud guarantee, and on its own it doesn't call your customers or walk your floor.

How much diligence is enough? Build a kill list

You can't diligence everything, and trying to is its own mistake. Sellers drop buyers who show up with a fifty-page internet checklist. So steal this, whether you ever hire anyone or not.

Before you spend a dollar on a review or a lawyer, write your kill list: the specific, measurable things that would end this deal. "Any single customer over thirty percent." "Real cash flow more than twenty percent under the memo." "Can't run day one without the seller." "The profit doesn't cover the loan payments." Rank them by how badly they'd hurt, chase the worst one first, and the moment one trips, you stop and you walk.

You don't need certainty to sign the letter of intent. You need enough conviction that paying for diligence is worth it. The letter isn't a commitment to close, it's permission to go find the thing that kills the deal. Good diligence verifies what you already believe. It is not a fishing trip.

The part after the wire

Here's the truth nobody selling you a report will say out loud. Doing the deal is the easy part. Running it, and not breaking the thing you just paid for, is the hard part, and it starts the morning after the wire clears. The report firm is gone by then. The first payroll, the employees testing you, the customers deciding whether they trust you, that's all yours.

That's the gap we work in. We check the profit before you wire, in plain English, and we don't vanish at close. Concretely: before close we call the top ten customers and read whether the relationships transfer, and we build the retention plan for the people who actually hold the place together, so day one has a plan instead of a prayer. The report proves the earnings existed. The handoff is what proves they keep coming. And that operator's read comes standard with us. Even a straightforward quality of earnings review comes with our honest take on whether the business actually runs, alongside the financial work, not instead of it, because a buyer wants both. It's the reason people send us the numbers in the first place.

Before you wire

So before you wire the money, run both reads. Get the quality of earnings; you need it. Then do the operator read on top of it: call the top customers, find out whether the place runs without the seller, and price what it would cost to replace him.

The report tells you the profit was real. After that, the only question that matters is whether it's still yours a year from now. That's the read to do, whoever ends up doing it. Do that, and you're already ahead of most of the people wiring money this year.