A seller tells you the business makes $600K a year. The tax returns show $380K. The P&L the broker sent over lands somewhere in between.
So which number is right? That is exactly what a quality of earnings report exists to answer.
If you are acquiring a business with SBA financing, understanding what a QofE actually shows, what a real quality of earnings report example looks like line by line, is not optional. It is the difference between buying a business that generates real cash flow and buying someone else’s problem dressed up in a flattering add-back schedule.
What a Quality of Earnings Report Actually Is
A quality of earnings report is an independent financial analysis that examines whether a business’s reported earnings reflect its true, ongoing ability to generate cash.
It is not an audit. An audit confirms financial statements follow accounting rules. A QofE goes further. It asks whether the earnings are real, repeatable, and free from manipulation or one-time distortions.
In a business acquisition context, the QofE is how you verify what the business actually earns before you commit $500K or more of your own money. SBA lenders and experienced buyers do not take the seller’s word for it. They want the adjusted, normalized number backed by source documents.
And here is the part that trips up a lot of first-time buyers: even the “adjusted SDE” figure the QofE produces is not necessarily the number you plug straight into your model. SDE is a broker-friendly metric. It tends to overstate true owner cash flow. We typically discount SDE by 15% to 50% to arrive at what we consider real, spendable earnings after you account for the actual cost of operating the business day to day. The QofE gets you closer to reality than the broker’s memo ever will, but it is still a starting point for your own underwriting, not the finish line.
Most QofE reports are prepared by CPA firms with M&A transaction experience. Expect to pay somewhere between $5,000 and $20,000 depending on complexity and deal size.
A Quality of Earnings Report Example: Line by Line
Say you are looking at a commercial cleaning company listed at $1.4M. The broker’s offering memo shows $450K in adjusted EBITDA. The seller says the business “basically runs itself.”
Here is a simplified version of what the QofE would actually examine:
Starting point: net income per tax returns. The tax return shows $180K in net income for the trailing twelve months. That seems low relative to the asking price, but the add-backs are where the story changes.
Owner compensation add-back. The owner paid himself a $220K salary. A market-rate manager to replace him would cost $80K. The add-back to SDE is $140K.
Owner personal expenses run through the business. The QofE team pulls bank statements (this is where proof of cash matters, because if the bank statements do not tie to the tax returns, none of the analysis holds up) and finds $28K in personal vehicle expenses, family health insurance premiums, and a phone plan covering five family members. All add-backs.
One-time items. There was a $35K legal settlement in year two of the three-year lookback. One-time. Add it back.
Customer concentration adjustment. Here is where the QofE earns its fee. One client represents 38% of total revenue. That client is a municipality on an annual contract up for renewal in four months. The QofE flags this as a revenue quality risk. The reported earnings may not be repeatable if that contract walks.
Adjusted SDE: $180K net income + $140K owner comp add-back + $28K personal expenses + $35K one-time legal = $383K.
That is a meaningful gap from the broker’s $450K. And the customer concentration risk is not a number you can add-back your way past. It is a structural problem that changes how you underwrite the deal entirely.
But remember: $383K is the adjusted SDE figure. From what we have seen across hundreds of deals, the real owner cash flow after you account for working capital needs (typically 2 to 6 months of operating expenses set aside), actual operator involvement, and the small costs that never quite make it onto the add-back schedule is lower. Discount that SDE number by 15% to 50% depending on the business, and you get closer to the truth.
What the Adjustments Section Tells You
Every quality of earnings report breaks adjustments into two categories: those that increase stated earnings and those that decrease them.
Buyers focus on the add-backs that increase SDE. That is the wrong habit.
The adjustments that cut earnings down are usually where the real risk lives. Common downward adjustments you will see include revenue recognized early through accrual-basis distortions, an owner paying himself below market rate (which masks the true cost of running the business), deferred maintenance that will become a capital expenditure the moment you take over, underfunded owner’s draw that artificially inflates retained earnings, and seasonal revenue being annualized in a way that overstates the full-year run rate.
When we review deals, we see sellers and their brokers lean hard on the upward add-backs and say very little about adjustments going the other direction. A clean QofE surfaces both sides of that ledger. Brokers represent the seller, not you. Their adjusted EBITDA number is a marketing document. Treat it accordingly.
How QofE Connects to SBA Underwriting
So that covers what the QofE shows you. The next question is what your lender does with it.
Your SBA lender is not going to accept the broker’s adjusted EBITDA at face value. They will want to see your QofE, and they will run their own normalization on top of it.
The number that matters to a lender is the debt service coverage ratio. We target 2.0x DSCR on our deals, with 1.5x as the absolute floor. Anything at 1.25x is dangerous territory, and most experienced lenders will not touch it. At a 2.0x target, a $1M SBA loan at current rates requires roughly $115K to $125K in annual debt service. That means the business needs to generate at least $230K to $250K in normalized cash flow to clear underwriting.
If the QofE comes back at $383K on that commercial cleaning example, your DSCR math looks workable at the $1.4M purchase price. If the customer concentration risk materializes and you renegotiate down to $1.1M, the numbers get even cleaner.
This is why the QofE is not just a due diligence checkbox. It is a negotiating tool. Meet on price, win on terms. The QofE gives you the documented basis to have that conversation from a position of strength rather than guesswork.
INTERNAL LINK: how SBA 7(a) underwriting works for business acquisitions
What a QofE Will Not Tell You
A quality of earnings report is backward-looking. It tells you what the business earned over the last two to three years. Full stop. It does not tell you what it will earn next year.
The QofE will not evaluate whether the industry is shrinking. It will not assess the owner’s client relationships and how sticky they are post-transition. It will not tell you if the key employee who runs operations is planning to leave the day he hears the business sold.
Those are qualitative due diligence questions. They sit alongside the QofE, not inside it.
The QofE is also not a substitute for an independent legal review of the asset purchase agreement, or a review of pending litigation, employee classification issues, or regulatory exposure. And it will not tell you how much working capital you need to keep the business running through the transition period. That is a separate analysis, and one you should not skip. We consider 2 to 6 months of operating expenses in working capital non-negotiable for any acquisition. Underfunding working capital is one of the fastest ways to turn a good deal into a cash flow crisis within 90 days of closing.
Think of the QofE as the financial floor. It tells you the minimum you need to know about earnings quality before you can confidently model the deal. Everything else in your due diligence builds on top of it.
When to Order One
Timing matters more than most buyers realize.
You do not order a QofE on day one when you are still evaluating whether you even want the deal. You also do not wait until two weeks before close. The right time is after the letter of intent is signed and you are in the exclusivity period.
At that point, you have agreed on a price (subject to diligence), the seller has agreed to give you access to financials, and you have a defined window to work in. That is when the QofE firm gets engaged, the data room opens, and the CPA team starts pulling apart the books.
Most QofE processes take three to five weeks from engagement to final report. Plan for that in your exclusivity timeline. A standard LOI exclusivity period runs 60 to 90 days, which gives you enough runway to get the QofE done and still have time to renegotiate or walk if the findings warrant it.
Side note: this is also one of the reasons we structure LOIs the way we do. If your exclusivity window is too short, the QofE timeline alone can eat up most of your diligence period and leave you no room to act on what it finds.
INTERNAL LINK: what to include in a letter of intent for a business acquisition
How to Read the Summary Table
Every QofE report ends with an adjusted earnings summary. This is the number that feeds your financial model, your SBA loan application, and your renegotiation if the numbers come in different from what the broker promised.
Here is the simplified version for the cleaning company example:
| Item | Amount |
|---|---|
| Net income per tax returns (TTM) | $180,000 |
| Owner compensation above market rate | +$140,000 |
| Personal expenses run through business | +$28,000 |
| One-time legal settlement | +$35,000 |
| Adjusted SDE | $383,000 |
| Customer concentration risk adjustment | Flag (not quantified) |
That final line matters. Some QofE reports will apply a haircut to revenue tied to concentration risk. Others will flag it qualitatively and leave it to the buyer and lender to decide how to factor it in.
When we work deals with customer concentration above 25% to 30% from a single client, we typically negotiate either a lower purchase price or an earnout structure tied to contract renewal. The QofE gave us the data to have that conversation. Without it, you are negotiating blind.
But again (and this is worth repeating): the $383K adjusted SDE figure is the starting point for your own analysis, not the ending point. SDE is inherently generous. Discount it appropriately before you decide this deal works at the listed price.
Frequently Asked Questions
What does a quality of earnings report include?
A QofE includes normalized EBITDA or SDE analysis over a two to three year lookback, a full add-back schedule with supporting documentation, revenue quality analysis covering customer concentration and contract stability, and identification of one-time items. The output is an adjusted earnings figure, though buyers should apply their own discount to SDE (typically 15% to 50%) before using it to model real cash flow.
How much does a quality of earnings report cost?
Most QofE reports for small business acquisitions in the $500K to $5M range cost between $5,000 and $20,000. More complex businesses with multiple revenue streams, subsidiaries, or accrual-basis accounting run toward the higher end. The cost is almost always justified. Catching a $150K overstatement in SDE before you close is far cheaper than discovering it after.
Is a quality of earnings report required for an SBA loan?
SBA lenders do not formally require a QofE report, but many will conduct their own earnings normalization. Having an independent QofE from a credible CPA firm makes underwriting smoother and gives your lender more confidence in the adjusted earnings number. On deals above $1M, most experienced buyers commission one regardless of whether the lender asks.
Who prepares a quality of earnings report?
QofE reports are prepared by CPA firms that specialize in M&A transactions. This is different from your local accounting firm. Look for firms with dedicated transaction advisory practices. The seller’s accountant should never prepare the buyer’s QofE. Independence is the entire point.
Can the QofE findings change the purchase price?
Yes, and this is one of the primary reasons to commission one. If the QofE comes back with adjusted SDE materially lower than the broker’s stated number, you have a documented basis to renegotiate price, restructure terms, or request an earnout provision. Sellers who push back on buyers ordering a QofE are a red flag worth paying attention to.
Running the Numbers Before You Run the Risk
A quality of earnings report example like the one above is not just a financial exercise. It is a reality check.
Sellers present their best number. Brokers represent sellers. The QofE represents you, and the data behind it. But even the QofE number needs your own discount applied before you trust it as real cash flow. SDE flatters. The math is the math.
Before you put $120K or more of equity into an SBA deal, you need to know the earnings you are buying are real, repeatable, and not dependent on one customer or one departing owner. And you need working capital set aside to actually operate the business once the keys are in your hand. The QofE is how you start finding that out.
Looking to Acquire a Business the Right Way?
Regalis Capital runs a done-for-you acquisition advisory service. We identify targets, run the financial analysis, manage the QofE process, negotiate deal terms, and guide SBA financing from LOI to close.
If you are serious about acquiring a business in the $500K to $5M range and want a team that reviews 120 to 150 deals a week working behind you, learn how our process works.