Understanding Quality of Earnings Before a Sale.

In nearly every sale of a privately held business, one report shapes the negotiation more than any other: the quality-of-earnings review. Commissioned by the buyer but felt by the seller, it tests whether reported profits represent sustainable operating performance or a mix of one-time benefits, accounting choices, and owner-related items. Owners who understand what the review examines — before a buyer's accountants arrive — negotiate from a stronger position and avoid the valuation cuts that follow surprises.

Start with the basic distinction. An audit states whether financial statements are fairly presented; a quality-of-earnings review asks what the earnings are actually worth to a new owner going forward. The reviewer rebuilds EBITDA by adjusting for items that will not continue under new ownership: above- or below-market owner compensation, personal expenses run through the business, one-time legal settlements, gains on asset sales, pandemic-era relief, and similar items. Each adjustment changes the earnings figure on which valuation multiples are applied, so small findings carry outsized weight.

Revenue quality receives equal attention. Reviewers look for concentration among a few customers, lumpy project timing presented as recurring income, bill-and-hold or percentage-of-completion judgments on long contracts, and related-party sales that might not survive a change of control. For government contractors and project-based manufacturers, they trace backlog to signed orders, test how revenue was recognized against costs incurred, and ask which programs end soon and which renew. Sellers who have already organized contracts, change orders, and renewal histories by program make this work faster and less adversarial.

Working capital is the second front. Buyers expect the business to arrive at closing with a normal level of working capital, and the review establishes what "normal" means from twelve or more months of history. Owners sometimes manage receivables, payables, or inventory aggressively ahead of a sale — collecting early, stretching vendors, deferring purchases — and reviewers normalize for exactly that behavior. A peg set from clean, consistent monthly closes is easier to defend than one reconstructed under pressure, which is another reason monthly discipline matters long before a process begins.

Consider commissioning your own review before going to market. A sell-side quality-of-earnings report, prepared by an independent accounting firm, lets you find the adjustments first: the personal items to remove, the reserves to correct, the customer accounting to clean up. It also gives your asking expectations a documented foundation rather than an advocate's estimate. The cost is real, but it is small beside a purchase-price reduction discovered late in diligence, when leverage has already shifted to the buyer.

Know what the review does not do. It does not value the business, verify every transaction, or bless the company's future. It is a point-in-time analysis of historical earnings quality, and buyers pair it with their own commercial, legal, tax, and operational diligence. Gaps elsewhere — unsigned contracts, compliance findings, environmental issues, employment disputes — move valuations just as surely. Treat the earnings review as necessary rather than sufficient, and prepare the rest of the diligence file with the same care.

The practical lesson is timing. Financial preparation cannot be compressed into the weeks after a letter of intent arrives; by then the numbers are what they are, and every adjustment favors the party discovering it. Owners who keep accrual books, close monthly, separate owner items from operations, and understand their own earnings adjustments a year before a sale enter diligence with fewer surprises — and surprises avoided are value preserved. As always, work through these questions with your own accounting and legal advisers before acting.

David Anderson is Co-Founder & Principal of Carroll & Anderson Capital Advisors.

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