Quality of Earnings Red Flags in Small Business Deals

When buying a small business, it's easy to get tunnel vision on the profits and growth shown in financial statements. But as Thornton O'Glove highlighted in his classic Quality of Earnings book, not all earnings are created equal. The headline numbers can be dressed up to look prettier than reality. In big public companies and mom-and-pop businesses alike, owners or accountants might (intentionally or unintentionally) employ tricks that boost short-term earnings at the expense of long-term sustainability. For a small business buyer or micro-PE investor, spotting these financial red flags early is crucial. It can mean the difference between acquiring a truly healthy, cash-generating company and overpaying for a house of cards.

Image: Cover of "Quality of Earnings" by Thornton L. O'Glove

Why Financial Red Flags Matter in Small Business Deals

A Quality of Earnings (QoE) analysis goes beyond a standard audit – it digs into whether the profits are real, recurring, and supported by cash, rather than one-off boosts or accounting gimmicks. In an acquisition, you're not just buying the past financials; you're buying the future stream of earnings and the cash those earnings should produce. The following are key financial red flags and takeaways (inspired by O'Glove's insights but tailored to small business deals) that every buyer should watch for. Each is paired with modern QoE best practices – like checking income sustainability, validating cash flow, and reviewing revenue recognition – to ensure you're seeing the true financial picture before you seal the deal.

Key Financial Red Flags to Watch For

1. Unusual Revenue Spikes (One-Time Windfalls)

Be wary if the company's revenue jumped dramatically in a short period, especially right before the sale. A sudden sales spike could be due to a one-off event that won't recur – like a major storm that temporarily boosted a roofing company's business. In a QoE review, ask "Is this revenue recurring?" or was it a lucky break. Truly sustainable income grows steadily; if last year's top line was propped up by a fluke contract or fire sale, you can't count on that going forward. Income sustainability is key – you want earnings that will continue under your ownership, not vanish next year.

2. Discretionary Expense Games (Unsustainable Cost Cuts)

Take a close look at expense trends. Owners can temporarily boost profits by slashing costs in ways that aren't sustainable. For example, delaying essential hires, skimping on marketing, or underinvesting in maintenance may fatten this year's profit, but it can mask underlying problems. On the flip side, some businesses run personal perks or "extra" expenses through the company (think owners' cars, family cell phones, or an outsized travel budget) and then remove these costs when presenting earnings to buyers. QoE best practice is to distinguish real, necessary expenses from truly discretionary ones. If profitability hinges on neglecting normal expenses – or if it improves only because the owner suddenly stopped paying themselves or their bills – that's a red flag that current margins aren't realistic long-term.

3. Aggressive Add-Backs to Profit

Add-backs are adjustments sellers make to show "normalized" earnings by adding back certain expenses. It's normal to exclude one-time costs or personal expenses in calculating EBITDA or Seller's Discretionary Earnings (SDE). But be skeptical of over-the-top add-backs. Are they adding back the owner's entire salary or other routine costs that will definitely recur under new ownership? Unjustified add-backs can artificially inflate profitability, for instance by claiming many regular expenses are "non-recurring". A thorough QoE analysis will scrutinize these adjustments – separating legitimate one-offs (e.g. a one-time legal fee) from those that are actually part of doing business (e.g. market-rate salaries, necessary repairs). If the "adjusted" earnings require reversing half the expenses on the books, you should question whether the business is truly as profitable as advertised.

4. Related-Party Transactions (Non-Arm's-Length Deals)

Small businesses often have cozy deals that might distort the financial picture. Perhaps the company buys from or sells to the owner's other business or family members. These related-party transactions can be used to pad the numbers. For example, a business could "sell" products to a sister company (or a friendly partner) right before year-end to puff up revenue, then quietly cancel the sale later. Or the owner might be paying themselves below-market rent for a building they own, temporarily suppressing expenses. The issue is these transactions aren't at arm's length – they may not continue (or may be repriced) once you take over. Modern QoE procedures will flag significant related-party dealings so you can adjust earnings to a market basis. Always ask: "If all customers and suppliers had to be unrelated and on market terms, what would the profits look like?" If the answer is very different from the stated financials, proceed with caution.

5. Timing Tricks in Revenue or Expenses

Watch out for accounting timing shenanigans. Two common forms are aggressive revenue recognition (booking revenue too early) and expense deferral (pushing costs to a later period). If you see a big revenue bump in the last month of the fiscal year, investigate whether the company offered deep discounts or lenient terms to get customers to buy early – essentially borrowing next quarter's sales to hit a target. Similarly, if expenses mysteriously dipped, perhaps maintenance was postponed or bills were left unpaid until after closing. These tactics can make one period look better at the expense of the next. A QoE analysis will check whether revenue is recognized in line with work actually done or products delivered. It will also look for any "irregular sales or timing strategies" – for example, premature revenue or delayed expenses – which distort true earnings. Revenue recognition policies that don't match economic reality (such as counting a full annual contract as revenue immediately when service is still to be provided) are major red flags. If the books show profits only because of timing games, those earnings will likely reverse later, hurting the buyer.

6. Profits Not Backed by Cash (Poor Cash Conversion)

A fundamental quality of earnings test is cash flow. As the saying goes, "Cash is king" – if profits don't turn into cash, something's fishy. The classic warning sign is a business showing healthy net income while operating cash flow is weak or declining. Maybe accounts receivable (money owed by customers) keeps growing much faster than sales – indicating revenue was recorded, but cash isn't coming in. Or perhaps inventory is ballooning, tying up cash, which could signal they're producing or buying more than they can sell. Working capital tricks can also boost short-term income (for instance, not writing off old, unsellable stock, which makes expenses look lower and profits higher). Quality earnings line up with cash – so QoE experts compare financial statements to bank statements to see if reported profits are fully supported by real cash inflows. If a company's "earnings" exist mostly on paper and not in the bank account, treat that as a glaring red flag. You might be looking at aggressive accounting or even potential fraud. At the very least, poor cash conversion means you'll have to pump in more working capital after acquisition, reducing the business's true value to you.

7. Hidden Liabilities or One-Off Boosts

Sometimes what isn't on the financial statements can be just as important as what is. Small businesses might have unrecorded or contingent liabilities that will eventually come due and hit earnings. Examples include pending lawsuits, warranties or refunds owed to customers, tax underpayments, or even simply bad debts and obsolete inventory that haven't been written off. Such hidden obligations mean the company's true earnings are lower than reported – because sooner or later, these costs will materialize. Another related red flag is any unusual income that flatters profits but won't recur: for instance, a gain from selling a piece of equipment or a forgiven loan (like a one-time COVID relief grant). QoE due diligence involves peeling back these layers – verifying liabilities and adjusting for any one-time gains or losses that don't reflect ongoing performance. If the financials have zero accrual for things like customer refunds or warranty claims, or if other income shot up thanks to a special situation, you need to factor that out. High-quality earnings should already account for routine losses and liabilities; if they haven't, you'll want to adjust the valuation or demand the issues be resolved before you buy.

Final Thoughts

Financial red flags aren't about nitpicking – they're about understanding whether a business's profits are real and repeatable. As a small business buyer, you should channel a bit of healthy skepticism, much like O'Glove urged for stock investors. Trust but verify each number. Connect the dots between the income statement and reality: Do the earnings hold up under scrutiny of contracts, bank statements, and common sense? By watching for these red flags and leveraging modern QoE practices (from revenue quality checks to cash flow validation), you'll be far better equipped to avoid overpaying for inflated earnings.