Quality of Earnings: Testing an SME's Profit Before You Buy

The asking price for a small business is a multiple of a profit figure. In a small business, that figure is almost never the one you will earn.

That is not usually dishonesty. The accounts of an owner-operated business were built to run the business and manage its tax, not to be bought. Records are informal, the owner is close to the detail, and a decade of small decisions about wages, rent, stock and timing has shaped the numbers in ways that make sense to the seller and mislead the buyer.

Quality of earnings is the discipline that closes that gap. It is the first and most valuable thing a buyer can do, because at a multiple of three, a $50,000 error in the earnings figure is a $150,000 error in the price.

Sources: ABS, Counts of Australian Businesses, released 18 August 2026; ATO small business benchmarks.

What is quality of earnings?

A quality of earnings review is not an audit. An audit forms an opinion on whether financial statements are fairly stated under accounting standards. A quality of earnings review asks a different question: of the profit reported, how much will still be there next year with you running the business and the seller gone?

It also differs from a valuation. A valuation applies a methodology to arrive at a value. Quality of earnings produces the input that methodology runs on. The two are related but separate pieces of work, which is why our business valuation service and our buyer due diligence work are scoped and priced separately.

Why is an SME's reported profit rarely the number to price from?

Six distortions account for most of the gap we see between a reported figure and a sustainable one.

1. Revenue and costs falling in different periods

A deposit banked this year for work delivered next year inflates this year. A large job invoiced before subcontractors are paid does the same. A twelve-month retainer recognised on receipt rather than across the term does it again. Match revenue to the cost of delivering it, look across three years rather than one, and read the balance sheet for work in progress, deferred income and accrued costs that the profit and loss hides.

2. Margins measured against yesterday's cost base

Historical margins describe the world the business used to trade in. Where input prices, wages or energy costs have moved and the owner has not passed them on, the margin in the reviewed period is higher than the one you will earn. This is common in businesses that import, that quote long jobs, and where a loyal owner has held prices for years. Test the trailing margin against today's costs and today's price list, not against last year's accounts.

3. Stock that has been estimated rather than counted

Gross profit is only as reliable as the closing stock figure. The ATO requires a business to take stock as close as possible to the end of each income year, and permits three valuation methods: cost, market selling value and replacement value, with a different method available for different items. Ask which method was used and whether a count was actually performed. Where stock has been rolled forward on an estimate, cost of goods sold is a guess, and obsolete items sitting on the balance sheet inflate both profit and net assets.

4. An owner who is not paid what the job is worth

In many small businesses the owner holds the key customer relationships, quotes the work, and pays themselves through a mix of modest wages and distributions. Restate that to what it would cost to employ someone to do everything the owner does. The blunt version of the question is the useful one: what is the market salary for the person who replaces the seller, and does the business still earn what the price assumes once that person is paid?

5. Related-party terms that will not survive settlement

Premises leased from the owner's self managed super fund at below market rent, a family member on the payroll who does not work in the business, or a family member working unpaid, all shift the real cost of operating. Restate each to an arm's length footing. Where the premises come with the deal, confirm what the rent becomes on transfer and on the next review, because that is the figure you will pay.

6. Spending that has been deferred rather than avoided

Profit can be propped up by not spending. Vehicles, plant and systems that should have been replaced get left, which flatters the current year and leaves you the bill. A business that has not reinvested is selling you tomorrow's capital spending as today's profit. Note the point carefully: because EBITDA is struck before depreciation, deferred capital spending does not show up as an earnings adjustment at all. It reduces the cash available to service your loan. Treat it there, not in the earnings bridge.

Which EBITDA add-backs are legitimate, and which are not?

Normalising earnings is legitimate and necessary. The line is crossed when the add-back schedule becomes a wish list. Apply three tests to every line: is it evidenced by a document, did it genuinely not recur across the three years reviewed, and can the business operate without it?

Where the seller cannot produce the evidence, the adjustment does not belong in the number. That is not an aggressive position. It is the same standard you would apply to your own accounts if a bank asked.

How can you test a seller's margins independently?

This is the most under-used test available to a buyer, and it costs nothing. The ATO calculates each ratio as the relevant amount divided by turnover excluding GST, multiplied by 100, and publishes a range for each industry across low, medium and high turnover bands.

Run the target's figures the same way and compare. A cost of sales ratio well below the industry range may mean the business buys better than its peers. It may also mean purchases are recorded under the wrong label, or that sales are not fully recorded. The ATO itself lists both kinds of explanation in its guidance on what it means to be outside the benchmark range, including expenses booked to the wrong account and wages or cash payments that have not been recorded.

Two cautions. The benchmarks are built on 2023-24 data, so they lag the current cost base and should be used as a direction-finder rather than a valuation input. And an out-of-range result is a question to put to the seller, not a conclusion. A business that sits outside its industry range for a good commercial reason is fine. A business that sits outside it and cannot explain why is telling you something.

Pair the benchmark test with a reconciliation of reported revenue to lodged business activity statements, income tax returns and bank deposits. Note that the ATO generally requires business records to be kept for five years from when the record was prepared or the transaction completed, whichever is later. A seller who cannot produce records inside that window has a record-keeping problem that is now your diligence problem.

What hidden liabilities transfer with the business?

These items rarely change the earnings figure. They change what the deal costs, and they belong in the price or in the contract rather than in the earnings bridge.

Long service leave is the one buyers most often get wrong. Under the Victorian Long Service Leave Act 2018, an employee accrues one week for every 60 weeks of continuous service, roughly 0.866 of a week a year, and can take it after seven years. Where a Victorian business is sold, Business Victoria is explicit that the period of employment with the old employer transfers to the new employer, and that this applies even where the sale documents attempt to exclude it.

Other entitlements follow the transfer of business rules in the Fair Work Act. The Fair Work Ombudsman sets out which entitlements a new employer must recognise and which a non-associated new employer can choose not to recognise, including annual leave and redundancy service. Whichever way that lands, someone pays. Work out who, and put it in the contract.

Superannuation deserves its own check. The rate is 12.00% for both 2025-26 and 2026-27. Where contributions have been paid late, the employer owes the super guarantee charge, which is the shortfall plus nominal interest at 10% a year plus an administration fee of $20 per employee per quarter, and which is not tax deductible. In an asset purchase that historical exposure generally stays with the seller's entity. In a share purchase you buy it. This is one of several reasons the asset or share decision is worth modelling before you sign, alongside the issues we cover in our note on shareholders agreements and their tax traps.

Worked example: from adjusted EBITDA to sustainable earnings

The figures below are illustrative and built to show the method. They are not a market benchmark, and the multiple used is simply the one the seller's own asking price implies.

A Melbourne trade services business is offered at $2,340,000 plus stock. The information memorandum reports adjusted EBITDA of $780,000, being reported EBITDA of $600,000 plus $180,000 of add-backs. At the asking price, that is a multiple of 3.0.

At the same 3.0 multiple, sustainable EBITDA of $505,000 supports $1,515,000, against the $2,340,000 asked. The earnings testing has moved the price by $825,000. Nothing in that work required a dispute with the seller. It required three years of ledger detail and a market salary reference.

The three items that do not belong in the bridge

This is where buyers double-count and lose credibility at the negotiating table. Each of the following changes the deal, and none of them is an earnings adjustment.

• Obsolete stock, $60,000. Of $310,000 of stock at valuation, $60,000 has not moved in 18 months. That is a reduction to the stock you pay for at settlement, not a reduction to earnings.
• Accrued long service leave, $48,000. Three employees have more than seven years of continuous service. In Victoria that liability transfers with the business. It is a settlement adjustment.
• Sustaining capital spending, about $35,000 a year. Two vehicles and a compressor are past replacement. Because EBITDA is struck before depreciation, this never touches the earnings figure. It reduces the cash available to service your loan.

Reconciling those into what you actually fund at settlement: $1,515,000 for the business, plus $250,000 of stock after writing off the dead $60,000, less the $48,000 of long service leave that transfers, gives $1,717,000. The $35,000 of annual replacement spending then sits in the cash flow model, not in the price, alongside the working capital you fund from day one. Each figure appears once. That is the test of a bridge that will survive scrutiny from a lender or from the seller's adviser.

Whether stock and leave are in fact adjusted at settlement depends on what the contract says, which is why the earnings work and the contract terms need to move together. We model the funding and the month-by-month cash position as part of business advisory and three-way forecasting.

What are the red flags in a quality of earnings review?

None of these means a business is a bad buy. Small business records are often untidy for innocent reasons. What matters is whether the seller can evidence the number they are asking you to pay for. Where they cannot, the position is straightforward: the unsupported amount comes out of the earnings figure, or the contract requires the seller to produce the evidence before settlement.

• Revenue that does not reconcile to lodged BAS, income tax returns and bank deposits
• An add-back schedule with no supporting documents behind it
• Only summary accounts offered, with general ledger detail withheld
• Ratios outside the ATO industry range with no commercial explanation
• Revenue heavily concentrated in a few customers, contracts or referral sources
• Stock rolled forward on an estimate rather than counted
• Plant and vehicles well past their replacement age with no recent capital spending
• Employee entitlement balances that have never been formally calculated

Sector matters here too. A medical or dental practice carries a different set of earnings questions, because so much of the revenue attaches to individual practitioners who may or may not stay. We cover that in our guide to buying a dental practice, and in our work with doctors, dentists and health practices.

Key takeaways

The figure that matters is sustainable earnings, and it is usually not the one on the front page of the information memorandum. Getting it right is the difference between buying a business and buying a number.

Frequently asked questions