Quality of earnings adjustments: the categories, with examples
Short answer
Quality of earnings adjustments turn reported profit into normalized, recurring earnings a buyer and lender can rely on. SOP 50 10 8.1 requires an SBA QoE to identify and document all add-backs and adjustments, naming five categories: non-recurring revenue or expenses, above- or below-market owner compensation, related-party transactions, deferred maintenance, and cash-basis vs accrual-basis differences. Each adjustment needs evidence, and adjustments can lower earnings as well as raise them.
The SBA's five named categories
| Category | Example | Direction | Evidence |
|---|---|---|---|
| Non-recurring revenue or expense | One-time insurance payout; lawsuit settlement; a move | Either | Settlement docs, invoices |
| Owner compensation | Owner paid $40,000 to run a role worth $110,000 | Usually down | Market pay data, role description |
| Related-party transactions | Rent paid to the owner's LLC below market | Either | Lease, market rent evidence |
| Deferred maintenance | Equipment overdue for overhaul | Down (or capex) | Service records, site visit |
| Cash vs accrual | Year-end receivables collected early; unpaid bills | Either | AR/AP aging, bank statements |
Adjustments that usually don't survive
- "Owner's personal expenses" with no receipts.
- "Cash sales not on the books" (and if true, a tax problem the lender can't use).
- Recurring "one-time" costs that show up every year.
- Pro forma savings the buyer hopes to make.
A worked calculation, from net income to DSC
A quality of earnings calculation starts from net income, adds back interest, taxes, depreciation and amortization to reach reported EBITDA, then applies documented normalization adjustments to reach adjusted EBITDA. On an SBA deal, the lender uses those QoE earnings in the debt service coverage test, which must be at least 1.25x for an Initial Acquisition. Below is a fully worked, illustrative example.
Illustration, not a real deal. A landscaping company, trailing 12 months.
Step 1: Net income to reported EBITDA
| Net income | $310,000 |
| + Interest | $20,000 |
| + Income taxes | $0 (pass-through) |
| + Depreciation and amortization | $95,000 |
| Reported EBITDA | $425,000 |
Step 2: Normalize
| Reported EBITDA | $425,000 |
| + Owner's spouse on payroll, no role | $45,000 |
| - Owner pay below market ($50,000 paid; $95,000 role) | -$45,000 |
| + One-time equipment repair after storm (insured loss not recurring) | $18,000 |
| - Rent from owner's LLC below market ($24,000 paid; $48,000 market) | -$24,000 |
| Adjusted EBITDA | $419,000 |
Check: $425,000 + $45,000 - $45,000 + $18,000 - $24,000 = $419,000.
Step 3: Debt service coverage
| Adjusted EBITDA | $419,000 |
| - Maintenance capex (lender estimate) | -$60,000 |
| Cash available for debt service | $359,000 |
| Annual debt service, proposed loans | $270,000 |
| DSC | 1.33x ($359,000 / $270,000) |
That last line matters: $359,000 x 0.94 = $337,460, and $337,460 / $270,000 = 1.2498x, just under 1.25x. A lender will look hard at anything that could shave 6% off earnings. See SBA DSC rules.
The owner compensation adjustment
SOP 50 10 8.1 lets lenders adjust the acquired business's cash flow for ownership compensation, replacing the seller's pay with what the new owner or manager will actually take. Every adjustment must be justified in the credit memo, and owner-compensation adjustments must be backed by a global cash flow analysis showing the principals can meet their obligations on the adjusted pay, at 1:1 globally. The applicant's compensation must also cover current obligations and living expenses.
Owner pay is usually the biggest single adjustment in a small-business acquisition and the easiest to get wrong in either direction.
Two tests, one number
The salary assumed for the new owner flows into both the business DSC and the household side of global cash flow. Pick it once, defend it, and use it consistently in the projections, the DSC and the global analysis.
Worked example
Illustration, not a real deal
Say a dental lab's seller paid himself $310,000 (salary plus distributions). Reported EBITDA after that pay is $240,000. The buyer will run the lab and take $160,000. New debt service: $300,000 a year.
| Line | Amount |
|---|---|
| Reported EBITDA (after seller's $310,000) | $240,000 |
| + Seller pay above buyer's pay ($310,000 − $160,000) | $150,000 |
| Adjusted EBITDA | $390,000 |
| Business DSC ($390,000 ÷ $300,000) | 1.30x |
| Buyer's household: take-home on $160,000 (assumed) + spouse income | $118,000 + $30,000 |
| Household obligations | $125,000 |
| Household coverage | 1.18x |
Both pass. If the buyer had planned $110,000 of pay to show 1.47x, household coverage would drop below 1:1 and the lender couldn't use that adjustment. Taxes here are rough assumptions, not tax advice.
Memo language checklist
- Seller's total compensation (salary, payroll taxes, benefits, distributions) by year.
- Buyer's planned compensation and source of market data.
- Why the adjustment is prudent, necessary and supported by ongoing operations.
- Global cash flow schedule from the personal financial statement and credit report.
- Consistency with projections and the QoE, if any.
Revenue quality: customer concentration
SOP 50 10 8.1 requires an SBA QoE to assess the quality and sustainability of revenue, naming customer concentration risk, contract continuity and the likelihood that revenue and margins will hold after the sale. In practice, the QoE shows revenue by customer over time, tests whether key contracts can transfer to the buyer, and checks whether big customers are tied to the seller personally. Concentration doesn't kill a deal, but it changes how much earnings a lender will lean on.
What the QoE looks at
- Revenue by customer, by month, for the TTM and two fiscal years.
- Top 1, 5 and 10 customers as a share of revenue, and how that's trending.
- Contract terms: length, renewal, termination for convenience, assignment, change of control.
- Gross margin by major customer.
- Whether relationships run through the seller personally.
- Receivables aging by major customer.
Stress test
Illustration, not a real deal. Cash available for debt service $500,000; annual debt service $360,000; DSC 1.39x. Top customer contributes $1,000,000 of revenue at a 25% contribution margin, so $250,000 of contribution.
| Scenario | Cash available | DSC |
|---|---|---|
| Base | $500,000 | 1.39x |
| Lose half of top customer | $375,000 | 1.04x |
| Lose top customer | $250,000 | 0.69x |
How lenders respond
- Size the loan to earnings excluding some of the concentrated revenue.
- Require more equity or seller standby debt.
- Use the seller's consulting period (up to 24 months under SBA rules) to transfer relationships.
- Confirm contract assignment or obtain customer consent before closing.
Related: personal goodwill.
How lenders treat each category in the credit memo
A QoE's adjusted EBITDA isn't automatically the lender's cash flow. Lenders start from the QoE figure, as the SOP requires on $3 million-plus deals, and then make their own prudent adjustments, each justified in the credit memo: unfunded capital expenditure, taxes and distributions where relevant, and changes the new owner will face. Where the QoE found deferred maintenance, for instance, the lender may deduct a reserve or require the work to be funded in the project. Where it found below-market related-party rent, the lender should check that the post-closing lease reflects market rent and that coverage still holds. Where an owner compensation adjustment increases cash flow, the SOP requires a global cash flow analysis showing the buyer can still meet personal obligations at 1:1.
The cleanest files show three columns side by side: the seller's proposed adjustments, the QoE's accepted adjustments, and the lender's final cash flow, so anyone reviewing later can see exactly where each number came from.
Adjustments that move in both directions
Sellers present add-backs; good QoE work also finds subtractions. The most common are a missing market wage for a role the owner performs, below-market rent to a related landlord that will rise after the sale, deferred repairs, and expenses the seller paid personally that the business will now carry. Lenders should be wary of any QoE where every adjustment increases earnings.
A balanced set of findings is one of the clearest signs that the provider worked for the lender rather than for the deal.
Common questions
Are adjustments always add-backs?
No. Below-market rent to a related landlord, deferred maintenance or an underpaid owner role reduce normalized earnings.
What evidence supports an add-back?
Invoices, contracts, bank records and a clear reason the item won't recur under the new owner.
Does the lender use the QoE adjustments?
Yes. SBA requires the lender to use the QoE earnings in the debt service coverage calculation.
Why EBITDA and not net income?
Interest, taxes and depreciation depend on the current owner's financing and tax choices. EBITDA is a cleaner starting point for what a new owner inherits.
Does the lender use EBITDA directly for DSC?
Lenders adjust for things like capex, taxes and distributions per their policy and the SOP; each adjustment is justified in the credit memo.
Related guides
Sources
This guide explains rules and practice in plain English. It isn't legal, tax or credit advice, and SBA and IRS rules change. Check the current SOP, regulations and your lender's requirements before you rely on anything here. Examples with made-up businesses are illustrations, not real deals.