Buying a Business? It Pays to Dig Deeper into the Financials

Whether you’re launching a new venture or expanding an existing one, it’s often easier to buy an established business than to build market share from scratch. Before signing a purchase agreement, however, you should review the seller’s financial records to understand what’s really driving the business’s profits and cash flow.

Comprehensive due diligence doesn’t just benefit buyers. Under recent U.S. Small Business Administration (SBA) guidance, certain SBA-financed business acquisitions may now require an independent quality of earnings (QoE) report as part of the underwriting process. The change underscores the importance of thorough financial due diligence. Here’s a closer look at what you should review to help identify risks, evaluate the sustainability of earnings and make a more informed decision.

Financial statements and tax returns

Start by asking the seller for financial statements and tax returns for the last three to five years. These records can help you evaluate trends in revenue, profitability and cash flow. Consistent growth and stable margins may indicate a healthy business. On the other hand, declining profits, volatile results or persistent cash flow challenges may warrant closer scrutiny.

Before you analyze performance, understand how the financial statements were prepared. Under U.S. Generally Accepted Accounting Principles (GAAP), the primary financial reports include:

• An income (or profit and loss) statement, which shows revenue and expenses for the accounting period,

• A balance sheet, which presents the book values of the business’s assets, liabilities and equity on the financial statement date, and

• A statement of cash flows, which summarizes cash inflows and outflows from operating, investing and financing activities during the accounting period.

GAAP statements follow accrual-basis accounting, meaning revenue and expenses are matched to the reporting periods in which they’re earned and incurred. Audited and reviewed financials may also include footnote disclosures that explain important information about the amounts reported in the financial statements.

Some businesses don’t prepare GAAP statements. Instead, they might use a special purpose framework or provide only internally prepared statements. These statements may exclude certain reports, line items and disclosures. Cash- or tax-basis statements may require accounting-method adjustments to analyze financial performance.

Also, compare financial statements with tax returns. Differences may be legitimate, but significant discrepancies should be explained. The objective is to determine whether the reported results accurately reflect the business’s economics.

Supporting records

Reports from the seller’s accounting software may help reveal issues that aren’t immediately obvious from the financial statements. During due diligence, consider requesting copies of:

• The current year’s budget,

• General ledger detail for selected accounts,

• Accounts receivable aging reports,

• Accounts payable aging reports, and

• Inventory summaries, if applicable.

For example, accounts receivable aging reports can show whether customers are paying on time or whether substantial amounts are overdue. Inventory reports may identify obsolete or slow-moving inventory.

You can also request bank reconciliations. Consistently reconciled accounts can indicate stronger bookkeeping practices and more reliable financial reporting. By contrast, incomplete or outdated reconciliations may signal that the records require additional verification.

Don’t overlook the importance of touring the business’s facilities. Observing operations firsthand may reveal inefficiencies, equipment concerns, excess inventory or other conditions that aren’t apparent from accounting records alone.

Normalizing adjustments

Many closely held businesses have expenses or financial arrangements that may not continue after a change in ownership. Examples may include:

• Above-market owner compensation,

• Personal expenses paid through the business,

• Family members on payroll,

• Above-market or below-market rent or related-party arrangements, and

• One-time gains or expenses.

During due diligence, these items are often adjusted to reflect what earnings would look like under typical operating conditions. This process is commonly referred to as “normalizing” the financial statements.

QoE reports

A common mistake buyers make is focusing on how much profit a business reports without considering the quality of those earnings. Effective October 1, 2026, certain SBA-financed acquisitions require an independent QoE report. This requirement generally applies to certain change-of-ownership loans when the purchase price is $3 million or greater, excluding applicable real estate. The new SBA requirement reflects growing recognition among lenders and investors that reviewing the acquisition target’s financial statements alone isn’t always enough.

A QoE report evaluates whether earnings and cash flow reflect the business’s ongoing operations and can support the acquisition debt. Such reports typically 1) analyze revenue, working capital, cash flow, and management’s earnings before interest, taxes, depreciation and amortization (EBITDA) figures and 2) verify various adjustments to the financial statements. In turn, the report may help reveal potential deal risks, such as:

• Customer or supplier concentration risks,

• Working capital shortfalls,

• Deferred equipment purchases and maintenance,

• Bad debts,

• Dependence on key personnel,

• Undisclosed liabilities and related-party transactions, and

• Pending litigation.

Even if you’re financing a deal yourself, an independent QoE report can help you interpret the business’s historical results in the context of today’s market conditions. If you commission your own report, you can customize it based on your needs and concerns.

For instance, you might want to break down gross profits by geographic region, salesperson or product line to understand what’s making money — and what’s not. Or you might ask for additional analysis of anomalies detected during your preliminary review of the financial statements and tax returns. A QoE report can also calculate relevant financial ratios and compare them with industry benchmarks for comparable businesses.

Professional support

If you’re thinking about buying a business, contact FMD for guidance through the due diligence process. We can help evaluate financial statements and tax returns, review supporting records, identify unusual transactions, assess financial and operational risks, and provide a QoE report if needed — before you sign on the dotted line.