How to Analyze SMB Revenue for Due Diligence

When buying a small or medium-sized business (SMB), analyzing revenue is critical to ensure the financial health of the business and avoid overpaying. The process involves validating reported earnings, identifying risks, and evaluating if the revenue is stable and reliable. Key steps include:

• Spot Revenue Risks: Look for customer concentration (e.g., one customer contributing over 15%), seasonality, or accounting discrepancies (cash-based vs. accrual-based).
• Collect Key Documents: Income statements, tax returns, bank statements, customer contracts, and accounts receivable reports are essential for a detailed review.
• Verify Revenue Accuracy: Use methods like bank deposit reconciliation and cross-check financial records to confirm reported revenue matches actual cash flow.
• Break Down Revenue: Analyze revenue by product, channel, or location, and assess recurring revenue vs. one-time sales. Watch for seasonal trends or customer dependency.
• Adjust for One-Time Earnings: Remove non-recurring revenue (e.g., insurance payouts or asset sales) to calculate sustainable EBITDA.
• Model Scenarios: Test how revenue might hold up under adverse conditions, such as losing a major customer or facing a market downturn.
• Refine Deal Terms: Use findings to adjust the valuation, structure earnouts, or include seller notes to mitigate risks.

Buying a Business? Consider a Quality of Earnings Sniff Test First!

Step 1: Gather and Organize Your Data

To get a clear financial picture, start by collecting at least three to five years of core financial statements. This will help you identify any inconsistencies or trends over time. Along with these statements, you'll need federal, state, and local income tax returns for the same period. Don't forget to include sales tax returns and employment tax filings.

Compile Your Financial Documents

Begin by requesting financial statements dated within the last 180 days to ensure you're working with the most up-to-date information. In addition to these, gather bank statements and the general ledger to reconcile reported revenue. Accounts receivable aging reports are also essential - they’ll give you insight into payment timelines and earnings quality. To assess concentration risk, compile a schedule of your top 12 customers along with their sales history over the last two years.

Sidharth Ramsinghaney, Director of Corporate Strategy and Operations at Twilio, highlights the importance of digging into operational metrics:

"The most revealing red flags often appear in month-over-month operational metrics rather than annual statements. Subtle variations in working capital patterns [can expose] underlying business model weaknesses".

Once you’ve gathered all the documents, the next step is to align each data source with a method for validation.

Map Your Revenue Data Sources

With your financial documents in hand, it’s time to align each source with a validation test. For instance, bank statements can be used for a "Proof of Cash" reconciliation, which helps uncover unrecorded transactions or potential fraud. To confirm revenue legitimacy, match accounts receivable with customer contracts. Cross-referencing tax returns with profit-and-loss statements is another way to ensure revenue consistency.

To streamline this process, consider organizing your data in a Virtual Data Room (VDR). A VDR offers a secure, indexed repository that allows your team and advisors to access documents efficiently.

How Kumo Helps with Data Preparation

If you're in the deal-sourcing phase, Kumo can simplify your work by providing early access to revenue data and financial snapshots for small and medium-sized business (SMB) acquisition targets. Kumo aggregates listings from multiple marketplaces and brokerages, allowing you to filter opportunities based on financial criteria before requesting full documentation. This approach helps you focus on promising targets and enter the due diligence phase with a clear understanding of which businesses deserve a deeper dive.

Step 2: Verify the Reported Revenue Numbers

To ensure accurate valuations and structure deals effectively, it's essential to confirm that the reported revenue aligns with actual bank and financial records. This step is especially important for small and medium-sized businesses (SMBs) that haven't undergone audits. Many smaller businesses lack strong internal controls, which can lead to discrepancies in their financial reporting. Start by reconciling bank deposits to verify the accuracy of the revenue figures.

Reconcile Bank Deposits with Reported Revenue

One effective way to validate revenue is through the proof of cash method, which matches general ledger transactions to actual bank activity. This approach helps confirm whether financial statements are both complete and accurate. Brian Sipes, from Kroll's Transaction Advisory team, underscores the importance of this process:

"For target's that are not audited, a proof of cash reconciliation is vital to validate the integrity of the reported financials and ensuring the reliability of earnings."

Begin by gathering a full year of bank statements and comparing them line-by-line to reported cash revenues. As you go, make adjustments for bank fees and credit card charges that are deducted before deposits. These should be recorded as separate expenses and added back to gross revenue to avoid understating the total revenue. Additionally, exclude non-revenue inflows like internal bank transfers, loan proceeds, and sales tax collected from customers. Sales tax is particularly important - if it's mistakenly recorded as revenue rather than a liability, it can artificially inflate earnings.

Be mindful of timing differences as well. Deposits recorded in the company’s books in one period but appearing on the bank statement in the next can cause temporary mismatches. These "cash-in-transit" discrepancies require adjustment. Missing records or inconsistent bank data should also raise red flags.

Common Discrepancy	Impact on Revenue	Corrective Action
Sales Tax Misclassification	Overstates revenue/earnings	Reclassify as a liability
Netted Bank Fees	Understates gross revenue	Record fees as expenses; adjust gross revenue
Timing Differences	Creates mismatches	Adjust for pending deposits or cash-in-transit
Interbank Transfers	Misclassified as revenue	Exclude from revenue calculations

Once you've reconciled deposits, the next step is to assess how revenue is recognized and ensure it aligns with service delivery.

Check Revenue Recognition and Timing

SMBs often use cash-basis accounting, where revenue is recorded when cash is received. However, buyers typically prefer accrual-basis accounting, which records revenue when the product or service is delivered. During due diligence, converting from cash to accrual accounting is a common practice that provides a clearer picture of whether revenue timing matches service delivery. Brian J. Sharkey, CPA at Kreischer Miller, explains:

"Sharing cash basis financial information can cause delays in the financial due diligence process, as the buyers will attempt to convert the financial information themselves."

Under ASC 606 revenue recognition standards, revenue must be connected to specific, distinct promises outlined in contracts. Missteps in identifying these performance obligations can distort revenue timing and may even require financial restatements. Be alert for warning signs like sales recorded before services are delivered or sudden revenue surges just before a sale date. Offering steep discounts to book early sales can also lead to a revenue drop-off after the deal closes.

It's also critical to analyze the accounts receivable aging report. If more than 10% of accounts are overdue by 90 days or more, this could point to a low-quality customer base or signal that reported revenue might not be collectible.

Cross-Check Multiple Financial Sources

The final step in verifying revenue involves comparing data across the profit-and-loss statement, tax returns, and bank statements. This three-way matching process can reveal discrepancies that might indicate revenue manipulation.

As you review these sources, look for mismatches in timing, amounts, or classification. Typically, this financial verification process takes one to two weeks and costs between $2,000 and $5,000. For a more detailed analysis, a Quality of Earnings (QoE) report - often completed in four to eight weeks - can cost upwards of $30,000, depending on the complexity. While the cost may seem high, these procedures often identify issues that standard audits miss. Audits tend to focus on the balance sheet at a specific point in time, whereas these reviews provide a broader look at the income statement over a period.

Finally, limited access to key financial records or personnel after a financing commitment can signal transparency issues and should not be overlooked.

Step 3: Break Down Revenue Components and Patterns

Once you've confirmed the accuracy of the reported revenue, the next step is to dig deeper into what drives the business's financial engine. By breaking revenue into specific components, you can pinpoint which areas contribute the most value and which might need attention. This analysis builds on the earlier verification process and lays the groundwork for evaluating the overall quality of revenue.

Segment Revenue by Product, Channel, and Location

Start by dividing revenue into product lines or service categories. This helps identify which offerings are performing well and which might be underperforming or consuming more resources than they return. Pay attention to the mix of recurring revenue (like subscriptions or maintenance contracts) versus one-time sales. Recurring revenue is often considered more reliable and valuable due to its predictability. A strong business typically shows a 70:30 split between recurring revenue from long-term contracts and income from new business.

Next, analyze revenue by sales channel - whether it’s direct sales, distributors, marketplaces, or affiliates - and by region. This can uncover differences in volume, profit margins, and potential risks tied to specific geographies. For small and medium-sized businesses (SMBs) operating across multiple regions, this breakdown can also reveal shifting market trends and opportunities for growth.

Spot Seasonal and Cyclical Patterns

In addition to segmentation, it's crucial to examine timing trends. Look at monthly revenue data over the past two to three years to detect any seasonal patterns. For instance, a retailer might consistently see a spike in revenue during the fourth quarter, signaling a seasonal dependency.

If the business uses cash-basis accounting, convert the data to accrual-basis to get a clearer view of when revenue is earned rather than when cash is received. This adjustment avoids misleading spikes caused by payment timing. To validate these patterns, cross-check reported seasonal peaks with actual bank deposits to ensure the revenue trends align with real cash flow.

Measure Customer Concentration Risk

Customer concentration is another critical factor to assess. Calculate the Customer Concentration Ratio by identifying the top three to five customers and their combined contribution to annual revenue. Ideally, no single customer should account for more than 10% to 15% of total revenue. If the top three customers contribute 60% or more, that’s a warning sign of over-reliance on a few clients.

To dig deeper, use the Herfindahl-Hirschman Index (HHI), which involves squaring and summing each customer's revenue share. A score closer to 10,000 indicates high concentration and a potential vulnerability to losing key customers. Additionally, review the terms of major contracts, especially clauses related to "change of control" and expiration dates, to evaluate the risk of non-renewal after an acquisition. If the concentration is high, model worst-case scenarios to see if the business could withstand the loss of its largest customer.

Concentration Level	Single Customer %	Top 3 Customers %
Low Risk	< 10%	< 30%
High Risk	> 15-20%	> 60%

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Step 4: Evaluate Revenue Quality and Durability

When assessing a potential acquisition, it’s essential to ensure that the revenue streams you’re counting on will remain intact after the deal closes. Unlike standard financial audits that focus on past performance and compliance with GAAP, a quality of earnings analysis shifts the lens toward future earnings stability. As Duedilio aptly puts it:

"How confident can we be that these earnings will continue?"

Once revenue trends are confirmed, the next step is to dig deeper into whether these earnings are built to last.

Check Revenue Quality

To gauge revenue quality, focus on two key factors: recurring revenue and margin consistency. High-quality revenue typically comes from subscriptions or long-term contracts - situations where customers don’t need to make repeated purchase decisions. On the other hand, revenue from one-off projects, windfall sales, or distressed transactions is less reliable since it’s unlikely to recur.

Margin consistency is another telltale sign. Examine whether profit margins are steady across different revenue streams. If you notice unusually high margins in certain areas, dig deeper to ensure they aren’t due to deferred maintenance or other temporary factors that could create future liabilities.

Identify and Exclude One-Time Revenue

One-time or unsustainable revenue can distort a company’s financial performance, so it’s crucial to adjust EBITDA accordingly. Look closely at revenue sources and flag items that may not carry over post-acquisition. Common examples include one-off consulting projects with no follow-up work or asset sales (like selling real estate or equipment) that were incorrectly recorded as operational revenue.

Be wary of practices like channel stuffing, where excessive inventory is shipped at the end of a period to artificially boost revenue. Signs of this include unusual spikes in fourth-quarter revenue or extended payment terms, which may indicate the company is borrowing from future sales.

For instance, in 2019, a quality of earnings analysis revealed that nearly 40% of a target company's reported earnings came from one-time asset sales. This discovery adjusted the sustainable EBITDA from $12 million down to $7 million. With transaction multiples often based on EBITDA, this $2 million overstatement at a 6× multiple could lead to a $12 million overpayment.

Once unsustainable revenue is flagged, it’s time to test how the business might hold up under pressure.

Test Revenue Stability with Downside Scenarios

To confirm revenue resilience, model potential downside scenarios. Instead of relying on simple trend lines, build driver-based models tailored to the business type. For example, use ARR roll-forward models for SaaS companies, order math for e-commerce, or GMV and take-rate models for marketplaces.

Develop specific scenarios, such as:

• A Recession scenario, which includes volume shocks and wider credit spreads.
• A Stagflation scenario, marked by weak growth and sticky inflation.

For each scenario, create two versions:

• A Passive case, reflecting the impact of external economic conditions alone.
• A Managed case, which factors in proactive measures like adjusting channels, reducing capacity, or tightening working capital terms to mitigate risks.

To ensure the business can weather short-term challenges, prioritize a 13-week cash flow model over annual EBITDA projections. This approach highlights whether the company can meet immediate obligations during a downturn. Additionally, monitor debt covenant headroom on a monthly basis to identify potential "trigger months" where bank agreements might be breached.

A scenario becomes significant if it leads to at least a 2% revenue shift, a 100-basis-point change in contribution margins, or a 50-basis-point swing in covenant headroom. This type of analysis helps you understand whether the business can endure losing a major customer, navigating a market downturn, or absorbing sudden cost increases - and whether you’re comfortable taking on that level of risk.

Step 5: Apply Revenue Findings to Valuation and Deal Terms

Once you've confirmed the quality and stability of the revenue, it’s time to use those insights to refine your valuation and structure deal terms. This step involves translating revenue findings into adjustments for valuation and incorporating protections to manage potential risks.

Adjust Earnings Based on Revenue Findings

Start by normalizing the reported earnings. This means removing any non-recurring items - like one-off asset sales, insurance payouts, or windfall revenue - to better reflect the business's ongoing performance.

If the company recently experienced a sudden spike in revenue, avoid relying solely on trailing twelve months (TTM) figures. Instead, use a three-year average or a weighted average to smooth out any anomalies. For example, if a business reported EBITDA of $575,000, $625,000, and $1,045,000 over three years, the simple average yields $748,000. Applying a 4× multiple to this average results in a valuation of $2.99 million, compared to $4.18 million if only the most recent year’s EBITDA is used. As Dave Gilbert, CEO of Proven, advises:

"Always red flags when you see EBITDA double the year they decide to sell. I'd take an average of the last three years after adjustments and go from there".

These adjustments lay the groundwork for structuring deal terms that address revenue-related risks.

Structure Deal Terms Around Revenue Risks

If risks tied to revenue remain, they should be shared between buyer and seller. Tools like earnouts and seller notes can help align incentives and adjust the purchase price if EBITDA declines.

For example, if a single customer accounts for 20% of revenue, consider structuring an earnout where part of the purchase price is contingent upon that customer staying with the business for 12 to 24 months post-close. This approach ensures the seller remains motivated to help retain key clients and protects you from a sudden revenue drop.

In cases where revenue has been volatile or experienced unproven growth, Michael Brophy of MI-BOX recommends adding safeguards:

"I would strongly encourage you to also build in some protection for a purchase price adjustment if EBITDA goes way back down. I think the best tool to accomplish this is through a large, forgivable seller note".

With this structure, a portion of the seller financing is forgiven if the business fails to maintain agreed-upon EBITDA levels during the first year or two after the sale.

Additionally, consider setting aside funds in escrow or holdback accounts to cover potential liabilities identified during revenue analysis, such as unresolved legal issues, compliance costs, or disputed receivables. These measures provide financial recourse if the revenue outlook deteriorates unexpectedly.

Document Your Revenue Analysis

After making adjustments and structuring protective terms, compile a clear record of your revenue analysis to back up your valuation. Create a concise investment memo or due diligence summary that outlines your findings. Include a side-by-side comparison of Reported EBITDA versus Adjusted EBITDA, breaking down each adjustment category, such as one-time revenue, unsustainable margins, or timing corrections. Add a brief narrative explaining the rationale behind each adjustment and its implications for future performance.

This documentation serves several purposes. It supports your valuation offer, provides a reference for discussions with lenders (particularly SBA lenders, who often discount extraordinary revenue years), and creates a paper trail in case of disputes after the deal closes. Most importantly, it forces you to evaluate whether the adjusted earnings justify the price and helps you assess the remaining risks with confidence.

Conclusion

Revenue due diligence goes beyond simply verifying past earnings - it’s about ensuring those earnings are reliable and sustainable. By systematically reviewing data and validating revenue streams, you can avoid overpaying and identify potential risks that might disrupt the deal after closing.

This process helps to separate genuine operational performance from revenue spikes that might be temporary. Elliott Holland, Founder of Guardian Due Diligence, emphasizes the value of this approach:

"A Quality of Earnings report can save buyers millions of dollars by identifying any financial irregularities that the seller might have missed or not disclosed".

Adjusting EBITDA for non-recurring items and normalizing it provides a valuation that reflects the business’s true financial health, rather than inflated projections. This clarity also enables you to structure deal terms - like earnouts, seller notes, or escrow holdbacks - that balance incentives and share risks effectively.

Using reliable tools can further enhance your due diligence process. For example, Kumo consolidates over 120,000 listings, offering early insights into revenue trends and financial benchmarks. This comprehensive view allows you to compare opportunities, spot irregularities, and act swiftly when a promising business emerges.

A detailed revenue analysis is key to making informed acquisitions and achieving long-term success. By confirming the quality of revenue, you strengthen your overall acquisition strategy and build a solid foundation for future growth.

FAQs

What documents are essential for reviewing SMB revenue during due diligence?

When reviewing the revenue of a small or mid-sized business during due diligence, several key financial documents are essential for ensuring accuracy and dependability. These include:

• Income statements (Profit & Loss) from the past three years to analyze sales, costs, and operating expenses.
• Balance sheets to evaluate assets, liabilities, and the effects on cash flow.
• Cash flow statements to understand cash movement from operations, investments, and financing activities.
• Tax returns (both federal and state) for the last three years to confirm reported revenue and profits.
• Revenue breakdowns categorized by product, service, or geography, along with any noticeable seasonal patterns.
• Customer contracts and recurring revenue agreements to assess the consistency and risks tied to revenue streams.
• Accounts receivable aging reports to review payment timelines and identify potential bad debts.

These documents collectively offer insights into revenue stability, growth patterns, and cash generation, enabling buyers to make well-informed decisions. Platforms like Kumo can help simplify the organization and secure sharing of these files, making the due diligence process smoother and more efficient.

How do you identify and adjust for one-time earnings in SMB revenue analysis?

Identifying and accounting for one-time earnings is a key step in understanding an SMB's steady, ongoing revenue. This ensures that temporary or unusual items - like asset sales or legal settlements - don’t skew your analysis.

To begin, examine financial statements from the past two to three years. Look for any unusual revenue spikes or anomalies that could signal one-off events. Examples of such items might include selling equipment, receiving government grants, or earning a one-time consulting fee. Once identified, calculate the value of these items, subtract them from the reported revenue, and arrive at a normalized figure that better reflects the business's recurring operations.

Tools like Kumo can make this process easier by consolidating financial data and highlighting irregularities. This allows you to focus on identifying sustainable revenue patterns, which are essential for due diligence and accurate valuation.

How can I verify the accuracy of a small business's reported revenue during due diligence?

To verify a small business's reported revenue, start by comparing tax returns with internal profit-and-loss statements to spot any inconsistencies. Next, use bank statements to match deposits with recorded sales. If the business utilizes a point-of-sale (POS) system, dive into the raw POS reports to confirm transaction volumes and average ticket sizes. For smaller transactions, observing customer activity or foot traffic can offer additional clues.

A quality-of-earnings (QoE) review takes this a step further by evaluating revenue-recognition policies, accounting for one-off items, and examining accounts receivable aging and customer concentration. To ensure accuracy, compare the financials to industry benchmarks or audited statements, which can help uncover any anomalies. Tools like Kumo can simplify this process by consolidating financial data and pinpointing discrepancies, making due diligence quicker and more thorough.

Related Blog Posts

• Cash Flow in Financial Due Diligence
• Seasonal Revenue Modeling for SMB Acquisitions
• Balance Sheet Forecasting for SMB Acquisitions
• High Customer Concentration: Risks and Solutions