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 rule - A quality of earnings report should help the buyer understand the business, not simply satisfy a lender - A QoE evaluates normalized financial and operational performance, but it is not the same as an audit - Direct access to QuickBooks or another accounting platform can provide a clearer review than relying on PDFs - Proof of cash helps determine whether reported revenue is supported by actual customer deposits - Roughly half of the transactions John’s firm reviews are stopped or materially changed during diligence - Finding a problem before closing may save a buyer from an expensive mistake - Transaction modeling helps determine whether the business can realistically support its proposed debt - Customer concentration, supplier risk, staffing needs, working capital, and owner dependence should all be evaluated - Add-backs should be supported by actual transactions and reviewed based on whether the expense will continue after closing - A large gap between reported earnings and adjusted earnings should be treated as a potential warning sign - Excessive or questionable add-backs can point to broader concerns about the seller’s business practices - Clean books can make a business easier to diligence, more attractive to buyers, and more valuable - A low-cost QoE that only restates accounting figures may miss important operational risks - Buyers remain responsible for conducting their own diligence, even when working with an SBA lender **Episode Highlights:** \[00:00] Why clean books make a company easier to sell and more valuable \[01:05] Important context about when this conversation was recorded \[02:20] John Hannum’s background as a CPA, CFO, and acquisition advisor \[04:15] What a quality of earnings report is designed to uncover \[06:10] Why nearly half of the reviewed deals do not move forward \[08:00] Using direct accounting access instead of relying on a crowded data room \[11:15] The difference between a QoE and a formal financial audit \[15:20] How proof of cash verifies reported revenue \[19:00] Modeling the transaction and testing whether the business can support its debt \[22:30] Reviewing customers, suppliers, margins, staffing, and working capital \[26:00] How seller add-backs are investigated and validated \[29:10] Jet skis, personal expenses, and other questionable add-backs \[32:20] Why excessive add-backs can signal larger problems within the business \[35:45] Preparing clean financial records during the final years before a sale \[39:00] Operational risks that may become problems after closing \[42:30] Why a quality of earnings report should be more than a spreadsheet \[46:15] Choosing an experienced diligence provider instead of checking a box \[48:30] The most unusual add-backs Jared and John have encountered \[50:00] How to connect with John and PPS Finance **Connect with John Hannum:** Website: https://ppsfinance.com **Connect with Jared:** If you have questions for Jared, visit:https://jaredwjohnson.comhttps://jaredwjohnson.com LinkedIn:https://www.linkedin.com/in/jaredwjohnson/https://www.linkedin.com/in/jaredwjohnson/ **DISCLAIMER:** The views and opinions expressed in this program are those of the guests and host. They do not necessarily reflect the views or positions of my employer. **Keywords:** quality of earnings, QoE report, John Hannum, PPS Finance, business acquisition due diligence, proof of cash, financial due diligence, operational due diligence, seller add-backs, adjusted EBITDA, seller discretionary earnings, transaction modeling, working capital, customer concentration, business valuation, acquisition financing, fractional CFO, QuickBooks due diligence, buying a business, business acquisition risks, clean financial records, mergers and acquisitions