Why Your Financials Aren’t As Clean As You Think

Most owners I talk to are pretty sure their books are fine.

Then a buyer’s quality of earnings team gets in there, and the story changes.

I’ve watched this happen too many times to count. The owner is confident. The CPA is confident. The financials look clean. And then the QofE comes back and there’s a $400K adjustment to EBITDA, going the wrong way, and the deal economics collapse.

This isn’t because the seller is lying. It’s because most small and mid-sized business books are built for taxes, not for selling.

What QofE actually finds

Quality of earnings is not an audit. It’s a buyer’s accountants going through your financials with one question: is the EBITDA we’re being shown the EBITDA this business actually produces, repeatably, sustainably, at arm’s length?

Here’s what they find, almost every time.

• Personal expenses run through the business. Cars, phones, “consulting fees” to family, country club dues, the truck the kid drives. These are normal in a privately held company. They’re also coming out of the EBITDA add-back schedule, and the buyer’s team is going to scrutinize every one. Some they’ll allow. Some they won’t. Every dollar they reject is a dollar of EBITDA you don’t get paid on. At a 5x multiple, $50K of disallowed addbacks is $250K off your check.
• Revenue recognized when cash hits. Cash-basis accounting is fine for taxes. It’s a problem for selling. Buyers want accrual. They want to see revenue earned in the period it was earned, expenses matched to that revenue, deferred revenue treated correctly. A cash-basis P&L can hide trend. A clean accrual P&L tells the truth.
• One-time revenue treated as ongoing. That big project last year that you’ll never repeat. That insurance settlement. The PPP forgiveness sitting in revenue. All of it has to come out. None of it is recurring.
• One-time expenses treated as ongoing. This one cuts the other way and it’s worth fighting for. Legal fees from a lawsuit you settled. The CFO search you ran. The new ERP implementation. Those are legitimate add-backs. But you have to document them, categorize them, and have the receipts. If it’s not documented, the buyer’s team won’t allow it.
• Working capital surprises. This is where deals get repriced quietly at the eleventh hour. The buyer expects a “normal” level of working capital to convey at close. If you’ve been stretching payables to make cash flow look better, or your AR is bloated with collectibles that aren’t actually collectible, the working capital peg moves against you. That can cost real money.
• Customer profitability gaps. Buyers will run gross margin by client. If your top three clients are also your worst-margin clients, that’s a story. If your “growing” segment is actually losing money on every order, that’s a story too. Most owners have never run this analysis on their own business.

What this means for you

If you’re three or more years from selling, you have time to address this. If you’re inside 18 months, you’re already late.

The fix is slow. It also isn’t the kind of work most owners can do alone, because it requires someone who has been through a transaction before sitting at the same table as the CPA who has not. The skill sets are different. So is the goal.

When clients come to me at this stage, the first thing we do is run a private QofE on their own books, before a buyer ever sees them. The findings are almost always uncomfortable. They are also almost always fixable. The owners who do this work 24 months ahead of a sale routinely close at numbers their CPAs told them weren’t possible. The owners who don’t, learn the hard way, in front of the buyer’s diligence team, when there’s no time left to fix anything.

What this is really about

Clean financials aren’t just about the sale. They’re about you being able to actually see your own business.

I’ve had owners go through this exercise and discover their margins are worse than they thought. Or that one segment of the business is carrying the rest. Or that the “growth year” was really a one-time event. None of that is fun to learn. All of it is better learned now than across the table from a buyer’s diligence team.

You can’t manage what you can’t see. You can’t sell what you can’t show.

If you didn’t know, now you know.