What a Quality of Earnings Report Really Tells You Before Buying a Business

This episode was recorded a few days before the SBA released its new rules taking effect October 1, including the requirement for a quality of earnings report on business acquisitions with a purchase price of $3 million or more. Because the conversation predates that announcement, it is not an explanation of the new SBA requirement. For a breakdown of the updated rules, listen to the previous episode.

In this episode, Jared Johnson sits down with John Hannum, CPA, CFO, and founder of PPS Finance, to explain what a quality of earnings report actually tells a buyer before an acquisition.

John explains why a QoE is not an audit, why it should be more than an accounting exercise, and how operational diligence can reveal risks that financial statements alone may miss. He walks through the process his team uses, including direct access to accounting records, proof of cash, transaction modeling, customer and supplier analysis, working capital requirements, and the review of seller add-backs.

Jared and John also discuss why buyers should not treat a QoE as a box to check for a lender. John shares why roughly half of the deals his firm reviews do not move forward and why discovering a problem before closing can be one of the best possible outcomes for a buyer.

They also share examples of questionable add-backs, poorly prepared reports, hidden operational dependencies, and financial records that may point to larger problems within a business.

Main Takeaways:

This episode was recorded before the SBA announced its new quality of earnings requirement and does not explain the updated ruleA quality of earnings report should help the buyer understand the business, not simply satisfy a lenderA QoE evaluates normalized financial and operational performance, but it is not the same as an auditDirect access to QuickBooks or another accounting platform can provide a clearer review than relying on PDFsProof of cash helps determine whether reported revenue is supported by actual customer depositsRoughly half of the transactions John’s firm reviews are stopped or materially changed during diligenceFinding a problem before closing may save a buyer from an expensive mistakeTransaction modeling helps determine whether the business can realistically support its proposed debtCustomer concentration, supplier risk, staffing needs, working capital, and owner dependence should all be evaluatedAdd-backs should be supported by actual transactions and reviewed based on whether the expense wil