How to Verify a Business's Financials Before You Buy

Test 1: proof of cash

Proof of cash is the single highest-value hour in small business diligence. Pick a month — ideally one the seller did not choose — and take the revenue the P&L reports for it. Then open the business bank statements for that month and add up the deposits. Adjust for the honest reasons the two differ: transfers between the company's own accounts, owner contributions, loan proceeds, refunds and chargebacks, merchant processor fees netted out before deposit, and payments received in the following month for work invoiced in this one.

What should remain is a small, explainable difference. Repeat for three or four non-consecutive months across the last two years, including at least one month in the seller's stated peak season and one in the trough. If reported revenue consistently exceeds traceable deposits by a meaningful margin and nobody can explain the gap, you have found the most important thing you will find in the deal.

Where possible, add a second corroborating source. Sales tax returns, merchant processor statements pulled directly from the processor's portal, and payroll filings all come from outside the seller's spreadsheet. Two independent sources that agree with the P&L is meaningfully stronger evidence than one.

Test 2: reconcile the P&L to the tax returns

Ask for three years of business tax returns and put them beside the P&Ls for the same years. Differences are normal and often entirely legitimate — accrual versus cash accounting, Section 179 and bonus depreciation treatment, year-end timing, and owner distributions all create real gaps. The test is not that the numbers match. It is that the seller or their accountant can walk you through each difference line by line without improvising.

Pay particular attention when revenue is higher on the P&L than on the return. That direction has only a few explanations, and most of them are either an accounting timing issue the accountant can name immediately or income that was not reported. If it is the latter, understand clearly what it means for you: an SBA lender will underwrite the return, not the story, so the financeable price falls to what the filings support.

Also compare the balance sheet across years. Inventory that never changes, receivables that grow faster than revenue, and a shareholder loan account that moves in large round numbers each are worth a specific question.

Test 3: audit the add-backs

The asking price is a multiple applied to adjusted earnings, and the adjustments are where optimism accumulates. Request the adjustment schedule and require that every line trace to a specific general ledger entry.

Defensible add-backs are expenses a new owner genuinely will not incur: one owner's compensation and benefits, a personal vehicle run through the company, a family member on payroll who does not work in the business, a concluded one-time legal matter, or the costs of a product line that has been discontinued.

Add-backs to challenge: any "one-time" expense that also appears in the two prior years, deferred maintenance reclassified as non-recurring, marketing cut in the year before sale so earnings look fatter, an owner salary added back in a business that will need a manager, and rent paid below market to a building the seller owns. That last one is common and consequential — if the business pays the seller $3,000 a month for a space that will cost $6,500 at market, the earnings are overstated by $42,000 a year, and at a 3x multiple that is $126,000 of price.

Finally, subtract what the add-backs quietly ignore. Depreciation is added back in both SDE and EBITDA, but in equipment-heavy businesses the assets genuinely wear out. Estimate realistic annual maintenance capital expenditure and deduct it before applying any multiple. The distinction between the two earnings metrics matters here too — see SDE vs EBITDA for why applying the wrong multiple scale to the wrong figure is the most expensive error in small business pricing.

What a quality of earnings review adds

A quality of earnings review is an accountant's independent opinion on whether reported earnings are real, recurring, and transferable to you. On lower-middle-market deals it is routine and the buyer pays for it. On an owner-operated business at the smaller end, a full engagement can be disproportionate to the deal — but a scaled version, where a CPA reviews the bank reconciliations, the adjustment schedule, revenue concentration, and working capital, is usually cheap relative to the pricing error it catches.

The reason to hire it out is not that the tests above are hard. It is that a third party asks the follow-up question you will not ask, because by week six of diligence you want the deal to work. That bias is real and it is expensive.

When a test fails

A failed test is not automatically a dead deal. Sort findings into three buckets. Re-price covers anything that simply lowers real earnings: an unsupportable add-back, below-market related-party rent, ignored maintenance capital. Recalculate earnings, apply the same multiple, and present the arithmetic. Restructure covers risk you can hold rather than pay for: shift consideration into a seller note or an earnout, widen the indemnity escrow, or extend the transition period. Walk is reserved for findings that break trust rather than numbers — documents that turn out to be edited, a discrepancy that changes explanation each time you raise it, or a refusal to produce bank statements at all.

Once you have the verified earnings figure, the rest of the deal follows from it. Our valuation guide covers building the multiple range, the negotiation playbook covers presenting a re-price without blowing up the deal, and red flags when buying a business covers the findings in that third bucket.

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