Quality of Earnings Reports for SBA 7(a) Acquisitions

A Quality of Earnings report for an SBA 7(a) acquisition tests whether a business's earnings can actually support the debt being underwritten -- scrutinizing owner compensation, "nonrecurring" add-backs, and how much of the profit depends on the current owner personally.

It answers a simple-sounding question: are the earnings on this business's books the earnings a buyer -- or a lender -- can actually count on? For an SBA 7(a) acquisition, that question has a very specific audience, and it shapes how the analysis gets built.

Same financial DNA, different question

The underlying QoE work has a lot of similarities across deal types, but the audience and purpose are different. On an SBA 7(a) transaction, I'm thinking much more through the lender's lens: does the historical earning capacity of this business support the debt it's taking on? Under current SBA rules, change-of-ownership transactions have specific underwriting requirements around historical or adjusted historical earnings and debt-service coverage, and QoE reports are also required for certain larger initial acquisitions and business expansions.

So I'm still testing revenue, margins, owner compensation, add-backs, and whether earnings are recurring -- but I'm particularly interested in whether the normalized earnings represent cash flow the lender can reasonably rely on. With a private equity or strategic buyer, the lens is broader: they're also looking at normalized EBITDA, but working capital, revenue quality, debt-like items, and other issues can directly affect valuation and deal structure.

Same financial DNA, different question. The SBA lender is essentially asking, "Can these earnings support this transaction and its debt?" The PE or strategic buyer is also asking, "What am I actually buying, what are those earnings really worth, and where could this deal surprise me after closing?" Either way, the add-backs get picked on. That's apparently just how this goes.

The add-backs that draw the most pushback

The ones I expect to get the most pushback on are owner compensation and the famous "one-time" add-back. With owner compensation, it's not enough to say the owner paid themselves $300,000, so let's add it back -- someone still has to perform whatever functions that owner was performing. The real question is what it would cost to replace those functions at market. Owner compensation normalization is a common QoE adjustment, and the analysis needs to account for the actual role the owner performs.

The other big one is anything labeled "nonrecurring." The immediate question is whether it's actually nonrecurring, or whether we just really want it to be. To defend an add-back, I want documentation: what the expense was, when it occurred, why it isn't part of normal operations, whether similar expenses show up in other periods, and why a new owner wouldn't reasonably expect to incur it going forward. A defensible QoE adjustment should be tied to source records and be testable. The goal isn't to make EBITDA prettier -- it's to normalize it. And if something has been a "one-time expense" three years in a row, that definition needs a second look.

What rushing the QoE actually costs you

The biggest mistake is treating the QoE like it's something standing between you and closing instead of something standing between you and a potentially bad deal. If you rush it, you can miss unsupported add-backs, nonrecurring revenue, changes in margins, or differences between reported earnings and actual cash activity -- areas an SBA QoE is specifically intended to examine. (The same underlying discipline shows up on the buy side generally -- see our piece on the M&A due diligence process for what else tends to get missed.)

That matters beyond negotiating with the seller, too. For applicable SBA transactions, QoE-derived earnings feed into the lender's debt-service-coverage determination. Everyone wants to close faster. Nobody wants to discover six months later that they bought really expensive EBITDA that never existed.

What a lender needs to be able to rely on the report

From the lender's perspective, the report needs to answer one fundamental question: can they actually rely on these earnings when underwriting repayment of this loan? That means not just handing over an adjusted EBITDA number, but showing how we got there -- reconciling the financial information, testing the adjustments and add-backs, looking at whether earnings are recurring and sustainable, and identifying anything in the financial history that could materially change the earnings picture. Current SBA-focused QoE guidance specifically addresses reconciliation of financial records and tax information, normalization of earnings, and documentation of adjustments.

Every material adjustment needs a trail. If owner compensation is adjusted, why? If something is supposedly nonrecurring, where's the support? If reported revenue doesn't reconcile the way it should, that gets explained rather than buried in a spreadsheet. The report also needs to clearly identify risks and limitations -- the job isn't to make the deal work, it's to give the lender financial information they can actually use to make the credit decision. The lender shouldn't have to take anyone's word for the number. The report should show them why the number deserves to be relied on.

The red flag small-business buyers overlook

One red flag buyers can overlook is how much of the profitability depends on the current owner personally. Before founding Turning Numbers, I owned a managerial accounting firm where I worked exclusively with small and midsized businesses, so I've seen firsthand just how many hats an owner can wear.

A business can have great-looking earnings, but then you start asking what the owner actually does every day -- handling sales, managing key customer relationships, overseeing operations, approving purchases, and filling gaps whenever something goes wrong. The financial statements show what that owner is paid; they don't necessarily tell you what it would cost to replace everything that owner actually does.

So when I look at owner compensation, I'm not just asking what the owner paid themselves. I'm asking: if this person walks out the door after closing, what does the buyer have to spend to replace everything they were doing? I also want to understand whether key customer and vendor relationships really belong to the business or belong to the owner personally -- a distinction that can matter a great deal when ownership changes. Sometimes what looks like a very profitable business on paper is profitable in part because the owner is doing the work of three people. Sometimes you're buying a business. Sometimes you're buying yourself a very expensive job. A buyer should know which one it is before closing.

Key Takeaways

• SBA 7(a) QoE work is lender-focused: can these earnings support this transaction's debt?
• Owner compensation and "one-time" add-backs draw the most scrutiny and need documented support.
• Rushing or skipping a QoE risks missing issues that feed directly into the lender's debt-service-coverage determination.
• A lender-ready report shows its work -- reconciliation, testing, and clearly stated risks -- not just a final EBITDA number.
• Owner-dependency is an overlooked red flag: profitability can hinge on tasks the business won't retain after closing.

If you're buying -- or lending against -- a small business through an SBA 7(a) transaction, contact us: a QoE report built for that audience can save you from a very expensive surprise.