Expense Trends in SMBs: Red Flags to Avoid

When buying a small or medium-sized business (SMB), relying on just one year of financials can lead to costly mistakes. Expense trend analysis - reviewing costs over 3–5 years - reveals patterns that uncover risks, hidden costs, and potential issues with profitability. Key takeaways:

• Why it matters: Shrinking margins, rising overhead, or sudden expense cuts before a sale can distort a business's true value.
• What to watch: Volatile costs, misclassified expenses, payroll irregularities, and unexplained discretionary spending.
• How to analyze: Use multi-year financial data, normalize for one-offs, and compare to industry benchmarks.
• Impact on valuation: Expense trends directly affect EBITDA, valuation multiples, and deal terms, such as earn-outs or price adjustments.
• Post-sale planning: Accurate expense data helps set budgets, manage cash flow, and improve cost controls after acquisition.

Expense Trends You Must Track for Your Small Business

How to Identify Expense Trend Red Flags

Spotting expense red flags in a small or medium-sized business (SMB) takes a careful look at historical financial data. To get a clear picture, review 24–36 months of consistent monthly financials (prepared under U.S. GAAP or tax-basis). This timeframe helps separate temporary cost changes from deeper, structural issues that could affect the business’s performance after a sale.

Start by collecting the right documents and standardizing the data to ensure consistency across periods. Once the data is clean, use analytical methods to spot unusual patterns and verify your findings by cross-checking financial statements with external records like bank statements and tax returns. This methodical approach ensures the financials accurately reflect the business’s true performance.

Step-by-Step Process for Expense Trend Analysis

To begin, request these documents from the seller, covering at least three years: monthly income statements, balance sheets, cash flow statements, a detailed general ledger export, trial balances, and a chart of accounts. These records help you consistently track recurring expenses like payroll, rent, utilities, software subscriptions, and the cost of goods sold (COGS). For smaller businesses, also ask for bank, credit card, and payroll statements to verify expenses, as bookkeeping practices can vary.

If available, request internal budgets, forecasts, or management reports from the same period. Comparing actual expenses to these documents can highlight potential issues. For example, frequent budget overruns or overly optimistic forecasts might signal weak financial oversight.

Once you’ve gathered the data, normalize it by removing one-off or non-operational items - such as legal settlements, forgiven PPP loans, or restructuring costs. Reclassify discretionary or owner-specific expenses (like personal travel or family payroll) to reflect what a typical buyer would expect post-acquisition. This step often reveals hidden profitability and clarifies the true cost structure. Align the chart of accounts across all periods for consistent categorization, then calculate monthly and rolling 12-month expense trends to get a clearer view of the business’s financial health.

A practical way to organize this data is to load three years of monthly financials into a spreadsheet, ensuring every month is accounted for and totals match bank statements and tax returns. Analyze year-over-year (YoY) and month-over-month (MoM) changes, rolling 12-month totals, and expense ratios (e.g., COGS as a percentage of revenue). Look for abrupt changes, seasonal shifts, or unexplained volatility. Flag any periods where expense ratios deviate significantly from historical norms, industry benchmarks, or known business events (like a major customer loss or the opening of a new facility).

This process is critical because discrepancies in expense trends can directly impact the business’s valuation and post-sale planning. For instance, identifying a sudden drop in marketing spend right before a sale, unusual spikes in contractor costs, or recurring late fees can uncover hidden risks. Once you’ve normalized the data and established baseline metrics, you can dive deeper using specific analysis techniques to identify red flags.

Analysis Techniques for Detecting Red Flags

Horizontal analysis examines changes in expense categories over time by comparing individual months or years to a base period. This approach highlights expenses growing disproportionately to revenue. For example, if software subscription costs are rising sharply while revenue remains flat, it’s worth investigating whether this spending supports growth or points to inefficiencies.

Vertical analysis, which uses common-size income statements, expresses each expense as a percentage of revenue for each period. This method simplifies comparisons across time and against industry peers, making it easier to spot margin changes caused by rising costs. For instance, if COGS, typically steady at 55% of revenue, suddenly spikes, it’s a signal to dig deeper.

Rolling 12-month views smooth out seasonal fluctuations by aggregating data from the most recent 12 months. This perspective can uncover gradual increases in recurring expenses, like rent or headcount, that might not be obvious in monthly comparisons.

Analyzing per-unit or per-customer metrics can reveal inefficiencies hidden in overall totals. For instance, if revenue per customer is stable but service labor costs per customer are rising, it could point to underpricing, scope creep, or a shift toward more demanding clients. These insights are especially useful for predicting how costs might scale after an acquisition.

Finally, compare the SMB’s expense ratios - such as payroll as a percentage of revenue or rent per square foot - to industry benchmarks. If a business’s expenses consistently fall outside these norms without a clear explanation, it could indicate inefficiencies, underinvestment, or aggressive accounting practices. These findings should inform your valuation, investment strategy, and post-acquisition plans.

Validating Financials with Supporting Documents

To ensure the accuracy of your analysis, validate findings by comparing internal records with external documents. The reliability of an income statement depends on the accuracy of its underlying data. Reconcile key expense categories - like rent, utilities, payroll, and supplier payments - by matching general ledger entries to bank or credit card statements, accounting for timing differences. This step can reveal errors, omissions, or even intentional misstatements.

For payroll, compare registers and third-party reports to income statement figures. For example, if reported payroll expenses are $50,000 monthly but payroll provider records show $42,000, investigate whether the difference comes from misclassified contractor payments, owner draws, or other factors.

Review vendor contracts and compare them to recorded payments. If a software contract costs $1,000 per month but bank statements show $1,500, the discrepancy could point to added fees, overages, or duplicate subscriptions.

Finally, cross-check tax returns with internal financials to confirm consistency in major expense categories, depreciation, and owner compensation. Significant differences - like $200,000 in owner compensation on a P&L versus $120,000 on a tax return - should prompt further investigation to determine whether they stem from legitimate accounting differences or unreliable bookkeeping.

For businesses that rely heavily on cash or have informal practices, scrutinize reimbursement policies, card statements, and supporting documents like receipts and invoices to confirm that spending is business-related. This step helps ensure you’re working with accurate, reliable financial data.

Common Expense Red Flags and How to Address Them

When you dive into the financial data and compare it with supporting documents, certain patterns may jump out as warning signs. These red flags can skew your understanding of profitability and even lead to overpaying for a business. Spotting these issues early and addressing them systematically is key to making smarter decisions about valuation, deal structure, and planning after acquisition. Below, we break down some common red flags and practical ways to refine your due diligence process.

Inconsistent or Volatile Cost of Goods Sold (COGS)

Volatility in COGS can directly impact gross margin consistency, making it a critical area to evaluate. Ideally, COGS should align predictably with revenue. If you notice gross margin percentages fluctuating wildly month to month or quarter to quarter, it’s a signal to dig deeper.

Normal COGS fluctuations often have clear explanations, such as seasonal demand, supplier price changes, or shifts in product mix. These should be traceable through vendor invoices and sales data. However, red-flag volatility - like sudden spikes or drops without documentation - can indicate issues. For instance, if COGS drops by 15% shortly before the business is listed for sale, but inventory levels and vendor payments remain unchanged, this could point to misclassification or incomplete expense reporting.

To address these concerns, request detailed records like inventory listings, purchase orders, vendor invoices, and shipping bills. Cross-check these with the general ledger and bank statements to ensure recorded COGS matches actual purchases and inventory movements. If discrepancies arise, get clarification from the seller and rebuild a consistent COGS baseline. Compare gross margin percentages over at least three years to industry benchmarks for similar U.S. small and medium-sized businesses (SMBs). Significant deviations should prompt further investigation before finalizing valuation.

Sudden Drops in Operating Expenses Before Sale

Sharp cuts in operating expenses before a sale can distort profitability and mislead buyers about post-acquisition costs. While some expense reduction is normal, abrupt drops in key areas - like marketing, maintenance, travel, professional fees, software subscriptions, or utilities - could signal an attempt to inflate earnings.

Focus on line items showing noticeable declines in the 6–18 months leading up to the sale. Compare current spending with multi-year averages to assess whether these cuts are sustainable.

To estimate realistic post-close expenses, calculate historical averages for each category and compare them to industry benchmarks for similar U.S. SMBs. Adjust for known changes, such as new contracts or planned hires, and create a "normalized" monthly expense run-rate. This figure will give you a clearer picture of what the business is likely to spend after the acquisition and help refine your valuation and cash flow projections.

Unexplained Increases in Discretionary or Owner-Related Expenses

Discretionary or owner-related expenses can obscure the true profitability of a business. While sudden expense reductions can inflate earnings, unexplained increases in areas like personal vehicle costs, family members on payroll, owner life insurance, club memberships, or personal travel disguised as business trips can hide real earnings potential.

Review general ledger details, credit card statements, and expense reports to pinpoint transactions that benefit the owner personally rather than the business. For example, one-time consulting fees tied to the owner's advisors or personal memberships can significantly distort the financial picture.

Document these items with descriptions and dollar amounts, then create a normalized EBITDA schedule that separates recurring business expenses from discretionary or one-off owner costs. This process often uncovers hidden profitability and offers a clearer view of the business's actual operating costs.

Expense Misclassification and Inconsistent Categorization

Misclassification of expenses can make trend analysis and forecasting unreliable. Common signs include large balances in "other" expense accounts, inconsistent use of account codes, or misplacement of costs - like recording direct labor under "general and administrative" instead of COGS. This can skew key metrics, such as gross margins.

To resolve these issues, standardize historical records by using a consistent chart of accounts. Rebuild income statements to ensure expenses are categorized correctly across all periods. This allows for an accurate comparison of trends and ensures your forecasts are based on reliable data.

Payroll and Contractor Irregularities

Payroll irregularities can significantly affect your operating model and post-acquisition budget. Payroll should follow predictable patterns, so watch for unexplained spikes, irregular bonuses, or shifts between W-2 employees and 1099 contractors without clear justification. For example, a sudden $75,000 bonus payment just before a sale or contractor expenses jumping from $5,000 to $25,000 per month without a corresponding revenue increase are red flags.

To normalize payroll, draft a post-acquisition organizational chart reflecting the roles and headcount needed to run the business. Convert stable contractor roles into employee positions where appropriate, considering legal and financial implications. Replace unusual bonuses with market-aligned salaries and performance incentives. Build a projected payroll schedule, including benefits, and compare this to the seller’s historical payroll to highlight any gaps or excesses.

Key ratios, like payroll as a percentage of revenue or revenue per full-time equivalent, can provide valuable insights. Compare these metrics across multiple years and against industry benchmarks. If payroll appears significantly lower than peers, it could indicate underinvestment in talent rather than efficiency, warranting further investigation.

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How Expense Trends Affect Valuation and Post-Close Planning

Building on the earlier analysis of expense trends, adjustments based on these insights can help ensure fair valuations and effective planning after an acquisition. By identifying and normalizing any expense-related red flags, you can translate these findings into valuation changes and a practical operational plan for the post-close period. These patterns directly influence the purchase price, deal terms, and the first year of operations.

Impact on Valuation and Deal Structure

Expense-related red flags often reveal that a seller's reported EBITDA may be overstated or unreliable. For example, if operating costs were artificially reduced in the year leading up to the sale - such as through deferred maintenance, understaffing, or cuts to marketing - it's important to adjust EBITDA to reflect realistic expense levels. These adjustments are critical in determining a fair price and structuring the deal appropriately.

Here’s a simple example: a 5% drop in profit margin on $1,000,000 in revenue results in a $50,000 reduction in profit. At a 5× EBITDA multiple, this change translates to a $250,000 decrease in the business’s value.

Businesses with stable and predictable expense patterns generally justify higher valuation multiples. If your analysis shows consistent gross margins, manageable overhead growth, and minimal discretionary fluctuations, you might feel comfortable applying market-standard EBITDA multiples for that industry and business size. On the other hand, irregularities - such as unexplained spikes in discretionary spending or sudden expense reductions before a sale - may warrant a more cautious approach. These could lead to using lower multiples, including earn-outs or performance-based payments tied to future financial results.

Certain red flags, like temporary cost reductions, inconsistent cost of goods sold (COGS), or unexplained payroll changes, often push buyers toward structuring deals with more contingencies. This could involve earn-outs, escrow arrangements, or holdbacks to mitigate risks. For smaller U.S.-based deals, such issues might even lead to part of the purchase price being financed as a seller note, creating shared incentives and a safety net if normalized EBITDA falls short of expectations.

Recurring issues, such as late expense recording, missing receipts, or frequent post-period adjustments, may require more detailed financial representations. Buyers might request specific provisions covering expense policies, related-party payments, or compliance with Generally Accepted Accounting Principles (GAAP). In higher-risk situations, a quality of earnings report could be required to validate certain financial representations.

Expense trends also impact working capital requirements, including payables, accrued expenses, and prepaid items. These factors directly influence the working capital peg and cash needs post-close. Reviewing 24–36 months of monthly expense data helps identify seasonal patterns, payment terms, and shifts in vendor or payroll practices. A trailing 12-month average, adjusted for known changes, can provide a realistic working capital target. For example, if a seller has extended payables from 30 to 60 days to improve cash flow, you might need to adjust the purchase price or set a higher working capital target to restore normal vendor terms after the deal closes. On average, U.S. small businesses carry about $84,000 in outstanding invoices, with nearly half reporting overdue payments of over 30 days, which can strain working capital and lead to increased reliance on credit lines.

These valuation insights also guide post-acquisition cost management. Below is a summary table of how different expense trends typically affect deal valuation and structure:

Expense Trend Signal	Likely Deal Impact
COGS rising faster than revenue over several periods	Lower normalized EBITDA, reduced valuation multiple, potential price adjustment
Sharp reduction in advertising or marketing before sale	Normalized EBITDA increases (after restoring realistic marketing spend), potential earn-out structure
Rising wage expenses while revenue and output lag	Identified cost-cutting opportunity; possible post-close layoffs or restructuring
Reimbursements through personal apps, missing documentation	Increased representations and warranties, escrow or holdback arrangements, more conservative projections
Large "miscellaneous" expense category	Additional diligence, normalization adjustments, and tax risk protections
Growing outstanding and late receivables	Higher working capital needs at closing, tighter covenants, lower effective purchase price

Planning Integration and Post-Close Cost Management

Once valuation adjustments are finalized, these insights feed directly into the operational budget for the post-close period. Expense trend analysis serves as a foundation for identifying areas to cut, reallocate, or invest to meet pro-forma EBITDA targets. After normalizing expense red flags in your financial model, you can build a realistic 12- to 24-month operating budget. This budget should align revenue goals with a sustainable cost base, moving beyond the polished figures presented in the sale materials. Key elements to include are updated payroll, marketing, maintenance, and technology costs, as well as revised working capital assumptions and planned synergies or system upgrades. These adjustments should translate into monthly cash flow forecasts that account for debt service, capital expenditures, and contingency reserves. This process may also reveal the need for additional liquidity or an expanded credit line.

Analyzing expense trends can help distinguish between essential staffing needs and temporary roles. By mapping payroll and contractor expenses to departments and revenue drivers, you can identify duplicated roles, underutilized contractors, or positions cut before the sale that may need to be reinstated to maintain service quality. A 6–12 month plan for hiring, reductions, or redeployment is especially important for U.S. small businesses, where labor often represents the largest cost and has a direct impact on EBITDA, customer retention, and compliance with employment laws.

If expense data shows heavy reliance on manual processes, frequent errors, or outdated tools, it may be time to upgrade accounting, expense management, or ERP systems. Implementing automated expense platforms can streamline reimbursements, improve documentation, and address inefficiencies. For example, upgrading inventory systems to reduce COGS volatility can lead to better control and lower overhead. In U.S. small business environments, aligning these updates with the fiscal year and reporting standards - ideally within the first 3–6 months post-close - can simplify the transition.

Multi-year expense data can also highlight which vendors, leases, or service contracts drive the highest recurring costs. This insight allows you to prioritize renegotiations, focusing on contracts with significant dollar amounts, automatic price increases, or unfavorable terms. For instance, if software subscription costs have risen without corresponding usage, consolidating licenses or eliminating unused tools could be a practical first-year integration step.

When sourcing deals, targeting businesses with stable expense trends and well-documented financials can save time and reduce post-close challenges. Tools like Kumo can help screen potential targets by aggregating deals from U.S. marketplaces and brokerages, allowing you to focus on businesses with predictable cost structures. By reviewing financial summaries for expense anomalies early in the process, you can streamline diligence and prioritize smoother integrations.

Using Kumo for Deal Sourcing and Due Diligence

Finding the right deals is essential when identifying expense red flags. Spending time and money reviewing businesses with hidden expense issues can be a drain on resources. A smarter strategy is to screen potential acquisitions early in the process, focusing on businesses with stable expense patterns and accurate financial reporting. This initial filtering sets the stage for more detailed financial due diligence later on.

Finding Deals with Kumo

Kumo simplifies deal sourcing by combining over 101,000 active listings from various brokers and marketplaces into a single platform. This means U.S. buyers can access a wide range of small to mid-sized business (SMB) acquisition opportunities without hopping between multiple websites. The platform also cleans up messy data and removes duplicate listings, ensuring you start with reliable information.

With Kumo's custom search filters, you can zero in on businesses that meet your specific financial criteria, such as EBITDA, revenue range, industry, or location. For example, if you're targeting service businesses in a specific region with steady margins and strong EBITDA, you can set those parameters, and Kumo will surface the most relevant opportunities.

One standout feature is Kumo's AI-powered listing summaries. These summaries cut through the jargon and provide clear, concise overviews of each listing. As Kumo puts it:

"No more vague, jargon-filled descriptions. Kumo AI changes all of that, by providing you with a clear and compact summary of each listing."

Kumo also tracks changes in key metrics and listing details over time, flagging inconsistencies like sudden shifts in reported EBITDA or adjustments to add-back figures. By tapping into over 100 million data points, Kumo delivers highly relevant results, making it easier to compare deals and identify those with predictable expense structures.

To keep your pipeline fresh, Kumo offers saved searches and real-time alerts. You can set alerts based on your financial criteria and get notified when new opportunities meet your standards. With over $538 billion in total annual revenue represented across its sourced deals, Kumo provides a comprehensive view of the U.S. SMB market, helping you benchmark expense and margin trends across industries and regions.

Adding Kumo to Your Financial Due Diligence Process

Once you've identified promising targets, Kumo can help refine your due diligence pipeline. While it doesn't replace traditional financial due diligence, it enhances the process by ensuring only high-quality deals make it through the initial screening. Use Kumo to apply consistent financial criteria before diving into detailed financial statements, tax returns, or general ledger data.

When reviewing listings, pay close attention to how expenses and add-backs are described. Businesses that clearly itemize add-backs - like owner salaries, one-time legal fees, or non-recurring costs - tend to have better-documented financials than those that lump expenses into vague categories.

To integrate Kumo into your due diligence process, consider a standardized workflow, such as:

• Initial screening with Kumo to evaluate financial quality
• Requesting detailed financials, including income statements, balance sheets, and tax returns
• Analyzing expense trends for consistency and stability
• Conducting a formal quality of earnings review

By filtering aggressively during the Kumo stage, you can ensure only the most promising candidates advance to the more document-heavy phases. Identifying stable expense trends early helps avoid surprises later in the process. Kumo’s centralized pipeline management tools also make it easy to track each deal’s progress and flag any expense-related concerns. For instance, if a business shows strong revenue growth but stagnant or declining EBITDA, this could signal rising operating costs that are cutting into profitability - an issue worth investigating further.

For U.S. buyers planning to use SBA 7(a) loans or other acquisition financing, lenders will scrutinize expense trends closely. They'll expect consistency between listing data, tax returns, and bank statements. Focusing on businesses with multi-year stability in margins and expenses can streamline the lending process and reduce the risk of surprises during underwriting.

When you receive detailed financials, cross-check them against the figures in the Kumo listing. Any major discrepancies - like significantly different EBITDA figures or undisclosed add-backs - should raise red flags about financial transparency. Kumo’s historical data and tracking features can also help you monitor changes in how expenses or margins are reported over time, making it easier to address concerns before moving forward.

Conclusion

Understanding expense trends is crucial for shaping valuation, structuring deals, and ensuring value creation after closing. In U.S. small and mid-sized businesses, where margins are tight and owners are deeply involved, consistent and well-documented expense patterns often provide a clearer picture of a business’s health than revenue growth alone.

Here are some key points to keep in mind:

• Examine expenses over several years to identify real patterns and filter out one-time anomalies.
• Adjust for owner discretionary spending and non-recurring items to calculate sustainable EBITDA figures.
• Cross-check trends with bank statements, tax returns, and payroll records to catch potential misstatements early.
• Compare major expense categories to industry benchmarks to spot areas where the business might be overspending, underinvesting, or operating efficiently.
• Turn irregularities into actionable adjustments - whether through dollar corrections, earn-outs, holdbacks, or tighter representations and warranties.

When red flags emerge - such as volatile cost of goods sold (COGS), sudden expense reductions, unexplained discretionary spending, or payroll inconsistencies - quantify their impact on EBITDA and cash flow. Use these insights to adjust purchase terms, renegotiate, or even walk away if necessary. Model potential scenarios, such as continued volatility or the reversal of pre-sale cost cuts, to understand their effect on margins. In higher-risk situations, consider post-close price adjustments tied to audited financials.

After closing, implement robust expense controls. Set approval thresholds in U.S. dollars, transition to a unified chart of accounts, and reconcile monthly variances against your deal model. Strengthen vendor onboarding processes, renew contracts carefully, and manage discretionary spending tightly. Regularly track key metrics like gross margin, operating margin, and per-unit costs to detect and address any deviations from your acquisition plan early.

To streamline these practices, consider integrating Kumo into your deal-sourcing workflow. Kumo consolidates over 101,000 active listings from multiple sources and uses AI to analyze expenses. Its custom filters allow you to screen for specific financial criteria - like EBITDA, revenue, industry, or location - so you can focus your efforts on the most promising opportunities. By tracking changes in key metrics over time, Kumo helps you identify inconsistencies, such as sudden EBITDA shifts or questionable add-backs, before committing significant resources.

Use Kumo for initial deal screenings, tag opportunities for deeper review once financials are available, and log findings about expense trends in your internal tracking system. Over time, compare actual post-close expense performance with what was indicated in the listing and due diligence materials. This ongoing feedback loop refines your search filters and strengthens your ability to spot both risks and high-quality targets.

If you’re working with investors, lenders, or boards, present expense trend findings in a clear, visual format. Show how normalized EBITDA and cash flow are calculated, highlight major adjustments, and flag unresolved issues. Include scenario analyses to demonstrate how margins and cash flow could shift if risks materialize, and explain how your valuation, deal structure, and protections address these risks. If the risk-reward balance becomes unfavorable, this disciplined approach helps you justify renegotiating or walking away while maintaining trust with your financial partners.

FAQs

How does analyzing expense trends influence the valuation and structure of an SMB acquisition deal?

Understanding how expenses fluctuate is a key step when assessing a small or medium-sized business (SMB) for acquisition. Spotting unusual patterns - like sudden cost surges, unexplained jumps in operating expenses, or irregular spending habits - can reveal a lot about the business's financial stability and long-term viability. These patterns aren’t just numbers; they directly affect how you value the business by uncovering risks or areas where costs could potentially be trimmed.

Expense trends also play a role in shaping the terms of the deal. For instance, if the analysis flags concerning cost patterns, you might negotiate adjustments - such as adding contingencies, tweaking the purchase price, or setting up earn-outs to address potential risks. By diving deep into expense trends, you can make smarter, more confident decisions and avoid unpleasant surprises after the acquisition.

What expense trends should buyers watch out for when evaluating an SMB?

When evaluating a business, pay close attention to unexplained or inconsistent expenses, sudden jumps in operational costs, or frequent reimbursements that lack proper documentation. These could point to financial mismanagement or sloppy record-keeping.

You should also watch for shrinking profit margins, recurring costs that seem out of line with industry standards, or unusually high discretionary spending. These patterns could hint at inefficiencies or more significant financial problems. Carefully reviewing expense reports and financial statements during due diligence is key to spotting potential risks and ensuring the business is on solid financial ground.

How can Kumo help identify stable expense trends when evaluating potential business acquisitions?

Kumo makes it easier to analyze expense trends by bringing together business listings from multiple sources onto a single platform. With its AI-driven tools and in-depth data analytics, you can identify patterns and flag potential financial issues with greater efficiency.

With Kumo, you can swiftly sift through listings, track expense trends, and base your decisions on solid data. This not only saves time but also minimizes the chances of missing crucial financial details during due diligence.

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