Glossary
9 Red Flags a Quality of Earnings Report Surfaces in SMB Deals
Across more than fifty lower-middle-market deals a year, the same patterns repeat. Most are not fraud. They are the ordinary things a small business does that quietly move EBITDA, and EBITDA moves price. A Quality of Earnings analysis exists to find them before close, not after. Here are the nine we see most often.
- Pre-sale expense dips
Costs fall unusually low for two or three months right before a business goes to market. Sometimes it is timing, sometimes materials bought ahead. Either way it makes trailing earnings look stronger than the run rate supports. We normalize the dip back to a defensible level. We see a version of this in roughly one in five deals.
- Year-end revenue stuffing
A large deposit invoiced days before year-end for work not yet performed reads as revenue but is unearned. Recognized in the period the work is actually delivered, the year-end number comes down.
- Add-backs that do not trace
The adjustments that fail diligence share one tell: they cannot be traced to the general ledger. We test every add-back item by item and show the management version next to the verified version. If it is real, it survives.
- Theft and “lost revenue” add-backs
Sellers sometimes ask to add back revenue they believe was lost to theft or shrinkage. It is one of the hardest adjustments to justify, because it rarely ties to specific invoices or documented events. Most of it does not survive.
- Non-operating income booked as revenue
Rent from a sublet tenant, or income from anything outside the core business, often sits inside the revenue line. It comes out so earnings reflect the business a buyer is actually acquiring. It can reappear in a separate cash-flow view, but not in core EBITDA.
- Rent and insurance the buyer will actually pay
What the seller paid historically is rarely what the new owner will pay. Leases renew higher, and insurance that ran cheaply through a group reprices standalone. We rebuild rent off the real lease terms and a fresh insurance quote, then apply those numbers across the period.
- Customer concentration hiding in a healthy total
One customer at twenty to forty percent or more of revenue, or a one-time project dressed up as recurring, changes the risk of the whole deal even when the total looks fine. We break revenue down by customer so the concentration is visible before close.
- Accounting-system migration breaks
A mid-year switch between accounting systems can corrupt the comparability of the books. When it does, we shorten the working-capital window and run a proof of cash from the point the data becomes reliable.
- Inventory that does not move
Balances frozen at the same number for months, items entered at retail instead of cost, and exchange units booked in ways that overstate cost of goods. Each is findable, and each moves the number.
Frequently asked questions
Do these red flags mean the seller was dishonest?
Usually not. Most come from timing, owner-specific costs, and working-capital realities, not deception. The analysis is built to separate the two.
Which red flag costs buyers the most?
Working capital the seller underestimates is the most common source of a last-minute dispute. See the net working capital peg for why.
Can a seller fix these before going to market?
Yes. A sell-side analysis surfaces and corrects the surprises first, so they do not derail a buyer’s diligence later.
Where to next
For the full narrative behind these patterns, read what a Quality of Earnings report actually finds, or see the complete Quality of Earnings due diligence guide. To talk through a specific deal, reach our transaction advisory team.
