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A seller's profit figure is the start of the conversation, and with new U.S. Small Business Administration (SBA) rules now requiring quality of earnings reports on larger deals, a closer look at the numbers matters more than ever.
Buying an established business can be a faster path to growth than building market share from scratch. You inherit customers, employees, and a track record. You also inherit whatever is hiding in the books. Before you sign a purchase agreement, it pays to understand what's actually driving the seller's profits and cash flow, and whether those results will hold up once the keys change hands.
What Is Financial Due Diligence?
Financial due diligence is a buyer's independent review of a target company's financial records before closing. It tests whether reported revenue, earnings, and cash flow are accurate and sustainable, flags risks the seller may not mention, and gives you a factual basis for negotiating price and terms. Think of it as checking the foundation before you buy the house.
Which Financial Records Should A Buyer Review?
Start with three to five years of financial statements and tax returns. Steady growth and consistent margins are encouraging. Shrinking profits, erratic results, or recurring cash crunches deserve a harder look.
How were the financial statements prepared?
Before comparing years, find out what you're looking at. Statements prepared under U.S. Generally Accepted Accounting Principles (GAAP) use accrual accounting and include an income statement, a balance sheet, and a statement of cash flows. Audited or reviewed statements also carry footnotes that explain the numbers. Many privately held businesses instead use cash-basis, tax-basis, or internally prepared statements, which can leave out reports, line items, and disclosures and may need adjustments before you can judge performance fairly.
It's also worth comparing the financial statements with the tax returns. Some differences are normal. Big, unexplained gaps are a question for the seller.
What supporting records tell the rest of the story?
The seller's accounting system often reveals what summary statements don't. Consider requesting:
- The current-year budget
- General ledger detail for key accounts
- Accounts receivable and accounts payable aging reports
- Inventory summaries, if the business carries inventory
- Bank reconciliations
A receivables aging report shows whether customers pay on time. Inventory reports can surface slow-moving or obsolete stock. Up-to-date bank reconciliations usually point to disciplined bookkeeping, while gaps suggest the records need more verification.
And get out of the conference room. A walk through the facility can reveal aging equipment, excess inventory, or operational bottlenecks that no spreadsheet will show you.
What Does It Mean To Normalize Earnings?
Normalizing adjusts a company's reported results to show what earnings would look like under a new owner and typical operating conditions. Closely held businesses often carry costs and arrangements that won't survive a sale, such as:
- Owner pay that's above (or below) market rates
- Personal expenses run through the business
- Family members on the payroll
- Rent or other related-party deals priced above or below market
- One-time gains or expenses
Stripping out these items gives you a cleaner view of the earnings you're actually buying, and that figure often drives the purchase price.
What Is A Quality Of Earnings Report?
A quality of earnings (QoE) report is an independent analysis of whether a company's earnings and cash flow reflect its ongoing operations and can support the debt used to buy it. It goes past the reported profit to ask a sharper question: How much of this will still be there next year?
A QoE report typically analyzes revenue, working capital, cash flow, and management's figures for earnings before interest, taxes, depreciation, and amortization (EBITDA), then tests the adjustments behind them. Along the way, it can surface deal risks such as:
- Heavy reliance on a few customers or suppliers
- Working capital shortfalls
- Deferred equipment purchases or maintenance
- Bad debts
- Dependence on key people
- Undisclosed liabilities or related-party transactions
- Pending litigation
Does the SBA now require a quality of earnings report?
For some deals, yes. SBA Standard Operating Procedure (SOP) 50 10 8.1 took effect Oct. 1, 2026. Under its change-of-ownership rules, lenders must obtain an independent QoE report for SBA 7(a) initial acquisitions and business expansions with a business purchase price of $3 million or more, excluding owner-occupied real estate. A report prepared for the seller doesn't satisfy the requirement.
The takeaway reaches beyond SBA borrowers. Lenders and investors increasingly expect more than a seller's financial statements before they commit capital.
Is a QoE report worth it if you're not using SBA financing?
Often, yes. Commissioning your own report lets you shape it around your concerns. You might break down gross profit by region, salesperson, or product line to see what's really making money (and what isn't), dig into anomalies from your first pass through the financials, or compare key ratios against industry benchmarks. Not every small deal needs a full QoE, but the bigger the check, the harder it is to justify skipping one.
Know What You're Buying Before You Sign
You bring the vision for the business. We bring a clear read on the numbers behind it. GBQ's transaction advisory services team helps buyers work through financial due diligence, from reviewing statements and tax returns to flagging unusual transactions and preparing quality of earnings reports. Our mergers and acquisitions tax and valuation professionals can round out the picture on deal structure and price.
If an acquisition is on your radar, now is a good time to start the conversation. Talk to an expert about your next acquisition. Empowering growth is only a conversation away.
Frequently Asked Questions
What is the difference between financial due diligence and a quality of earnings report?
Financial due diligence is the full review of a target's financial records before a deal closes. A quality of earnings report is one key piece of it, focused on whether reported earnings and cash flow are accurate, recurring, and able to support acquisition debt.
When does the SBA require a quality of earnings report?
Starting Oct. 1, 2026, SBA 7(a) initial acquisitions and business expansions with a business purchase price of $3 million or more, excluding owner-occupied real estate, generally require an independent QoE report obtained by the lender.
How many years of financial records should a buyer review?
Three to five years of financial statements and tax returns is a common starting point. That window is usually long enough to spot trends in revenue, margins, and cash flow.
What are transaction advisory services?
Transaction advisory services help buyers and sellers evaluate, structure, and complete deals. They often include financial due diligence, quality of earnings analysis, tax structuring, and valuation support.
