Spotting Inflated Earnings and SDE Red Flags in an Ontario Business Purchase

Almost every business-for-sale listing leads with an earnings number — often Seller's Discretionary Earnings (SDE) or an adjusted EBITDA figure — that's meant to show a buyer what the business really generates once you strip out one-off expenses and owner perks. In principle, that's a reasonable thing to want to see. In practice, it's also the single easiest number in a deal to inflate, whether deliberately or through overly optimistic accounting.

Because valuation is often expressed as a multiple of this adjusted earnings figure, an inflated starting number doesn't just mislead you about profitability — it can mean you're overpaying for the entire business. This article is not about pricing multiples (those are deal-specific and shouldn't be treated as a fixed rule), but about how to scrutinize the earnings figure itself before you rely on it.

What "Add-Backs" Are Supposed to Do

Sellers typically start with the business's reported net income or pre-tax profit, then add back items considered non-recurring, discretionary, or personal to the current owner — the theory being that a new owner wouldn't necessarily incur these same costs. Legitimate add-backs might include the owner's above-market salary, a one-time legal settlement, or a genuinely non-recurring repair.

The problem is that "add-back" can become a catch-all category that sellers (or their brokers) use to justify almost any deduction from expenses, inflating the earnings figure well beyond what the business actually generates in cash.

Warning Signs Worth Investigating

• A long list of small, vaguely described add-backs that individually look reasonable but collectively add up to a large percentage of total earnings.
• Personal expenses run through the business that seem inconsistent with how a normal, arm's-length operator would run it — travel, vehicles, family payroll — without clear documentation separating personal from business use.
• "One-time" expenses that recur year after year in the financials, despite being labelled non-recurring each time.
• Revenue recognized earlier than it should be, or unusually large invoices booked right before the sale process began.
• Add-backs with no supporting paper trail — if the seller can't produce an invoice, contract, or bank record backing up a claimed add-back, be skeptical of including it.
• Inconsistent numbers across documents — the figure quoted in marketing materials, the figure in the financial statements, and the figure in the seller's verbal pitch don't match.
• A sudden, unexplained improvement in margins in the final year or two before the business went on the market, without a clear operational reason.
• Related-party transactions — sales to or purchases from businesses owned by the same seller or their family, priced in a way that flatters the target business's numbers.

None of these signs prove wrongdoing on their own. They're reasons to ask harder questions and request supporting documentation — not necessarily reasons to walk away.

How to Verify the Numbers

1. Request the underlying financial statements, not just a summary or a broker's "cash flow analysis" — ideally reviewed or audited statements, and at minimum the accounting records behind them.
2. Ask for source documents for every material add-back — invoices, contracts, bank statements — rather than accepting a spreadsheet line item at face value.
3. Compare multiple years of financials side by side to spot trends, one-off spikes, or inconsistent categorization from year to year.
4. Cross-check reported revenue against tax filings and HST remittances where possible — a business's HST filings should broadly track its actual sales activity, and inconsistencies deserve an explanation.
5. Have an accountant run a proper quality-of-earnings review for anything beyond a small transaction — this is standard practice precisely because sellers (even honest ones) tend to present numbers in the most favourable light.
6. Ask why now. A seller's stated reason for selling should be broadly consistent with what the financials show; a business supposedly thriving that's being sold in a rush, with pressure to close quickly, deserves extra scrutiny.

A Buyer's Earnings Verification Checklist

• [ ] Obtained full financial statements, not just a summary earnings calculation
• [ ] Reviewed at least two to three years of comparable financials
• [ ] Requested source documentation for every add-back over a meaningful threshold
• [ ] Cross-checked reported sales against HST filings where feasible
• [ ] Identified and questioned any related-party transactions
• [ ] Engaged an accountant for a quality-of-earnings review on anything beyond a small deal
• [ ] Confirmed the seller's stated reason for selling is consistent with the financial picture

Frequently asked questions