Key Takeaways
- Read the profit-and-loss statement, balance sheet, general ledger, tax returns, payroll, billing, and bank activity as one reconciled system.
- Separate service month from cash month, especially for prepaid tuition, family deposits, subsidy claims, and receivables.
- Trace each adjustment to a ledger entry and include replacement costs for owner work that continues.
- Review monthly classroom and payer detail; annual totals hide seasonality, room closures, temporary support, and collection changes.
- Build the closing working-capital schedule from balance-sheet accounts and cash timing instead of a generic percentage.
Begin with the basis and the books
Ask who prepares the statements, which entity and locations they cover, whether they use cash, accrual, or tax basis, how often accounts close, and whether prior periods can change. Obtain the chart of accounts and full general ledger, not just formatted reports. A clean-looking income statement can combine multiple sites, post owner expenses to vague accounts, or recognize subsidy in the month received rather than the month served.
Cash-basis records show receipts and payments. Accrual records attempt to match revenue and expense to the period earned or incurred. Neither label guarantees quality. A small operator may keep tax-basis books that are useful for filing but insufficient for purchase-price allocation, working capital, or monthly earnings quality. Reconcile basis differences through accounts receivable, deferred revenue, accounts payable, accrued payroll, and prepaid expenses.
Preserve versions. Export monthly profit-and-loss statements, balance sheets, general ledger detail, journal entries, and trial balances for at least three complete years and current year to date when available. Lock the data-room copy or record file hashes and export dates. If books change during diligence, request a bridge identifying each edit, reason, source, and affected period.
| Statement or record | Main question | Essential tie-out | Common problem |
|---|---|---|---|
| Profit and loss | What was earned and spent? | Ledger, tax return and operating detail | Annual totals hide timing and mix |
| Balance sheet | What is owned or owed at a date? | Aging, statements, contracts and debt | Stale receivables or deposits netted away |
| General ledger | What created each account total? | Invoices, payroll and bank entries | Vague “miscellaneous” classifications |
| Cash flow | Why did cash change? | Beginning and ending cash | Profit treated as distributable cash |
| Tax returns | What was reported to government? | Books-to-tax reconciliation | Different entities or fiscal periods |
| Operating systems | What service produced the accounting? | Child billing and payroll to bank | Dashboard accepted without raw exports |
Rebuild revenue from the child level
Create a monthly de-identified roster with child identifier, classroom, payer, schedule, contracted rate, discounts, subsidy authorization, fees, billing, credits, receipts, and ending balance. Sum it to the billing-system revenue report, then to the general ledger. Trace private receipts through merchant settlement and bank deposit. Trace agency receipts through remittance detail and bank deposit.
This establishes tuition realization. Posted tuition multiplied by headcount overstates revenue when schedules are part time, discounts apply, children start or leave mid-month, credits are issued, or balances go unpaid. A year-end ledger balance can understate bad debt when old amounts remain without a realistic collection path. Analyze aging, write-offs, refunds, chargebacks, and payment plans by payer type.
For subsidy, keep service period separate from cash period. Authorizations may expire or change; parent copays may not be collected; claims may be denied or recouped; payment practices vary by state. Match the general-ledger entry to authorization, attendance or required service evidence, claim, remittance, copay, and deposit. Analyzing subsidy revenue provides the program-specific diligence.
Registration, activity, supply, transportation, late, and withdrawal fees need their own classification. Determine whether each is earned immediately, relates to future service, is refundable, or produces an associated cost. Family deposits and prepaid tuition often create a liability because the operator owes service or a refund. A closing that transfers the obligation without its cash needs an explicit adjustment.
Read payroll as both cost and capacity
Reconcile gross wages from the payroll register to payroll expense, cash disbursements, payroll tax filings, and year-end wage reports. Then classify every person by site, role, classroom, credentials, hourly or salary status, scheduled hours, overtime, benefits, and employment status. Separate teachers, floaters, director, administration, food, transport, and facilities.
The financial statement tells you what payroll cost; the staffing grid tells you whether it lawfully and sustainably operated the rooms. Match timecards to room schedules and enrollment. Include paid breaks, leave, substitutes, training, meetings, opening and closing, and administrative time. If a center held rooms open through unpaid owner coverage, add a replacement cost rather than treating the missing wage as margin.
Payroll percentage alone is not a benchmark. The denominator changes with age mix, hours, tuition, subsidy, and occupancy; the numerator may omit owner work, contractors, benefits, or payroll taxes. BLS national wage data are context, not the local budget. Use actual wage history, current recruiting, offers, benefit cost, and state qualifications to model ongoing labor.
Owner compensation deserves a role schedule. List hours and duties in director work, classroom coverage, billing, tours, HR, purchasing, bookkeeping, maintenance, and family matters. Decide what the buyer will perform and what must be hired. Add back compensation only to the extent appropriate for the selected SDE or EBITDA framework, then subtract the market replacement expense required by that buyer model.
Analyze operating expenses for recurrence
For each material account, compare monthly amounts, vendors, invoices, payment method, and operating driver. Food should connect to enrollment, meals, reimbursement, and waste. Supplies should distinguish classroom consumables from durable equipment. Insurance should match current policies and exposure. Repairs should be separated from capital replacements without ignoring deferred maintenance.
Occupancy includes more than base rent. Capture common-area charges, property taxes, insurance, utilities, maintenance, security, trash, snow, landscaping, and landlord reimbursements. Read the lease to determine who pays what and when escalations occur. For owner-occupied or related-party property, normalize a defensible market rent and evaluate the real estate separately.
Professional fees, legal matters, consulting, software, franchise charges, advertising, background checks, training, licensing, transportation, and merchant fees may recur even if one vendor changes. A buyer should not remove an expense just because it has the seller's name on it. Ask what function it performs and what replaces it.
Temporary grants or relief payments require separate schedules. Record the program, award period, restrictions, recognition policy, cash receipt, obligations, and end date. Do the same for expenses funded by the program, especially wage supplements that employees may expect to continue. Normalize both sides consistently rather than removing revenue while leaving or removing expense opportunistically.
Make every adjustment auditable
Build a recast schedule from reported earnings to normalized earnings. Each line needs account, date or period, amount, evidence, rationale, recurrence conclusion, tax treatment for adviser review, and replacement offset. Distinguish owner-specific, nonrecurring, nonoperating, related-party, accounting reclassification, and pro forma adjustments.
SDE and EBITDA are not interchangeable. SDE is often used for an owner-operated business and generally contemplates one owner's compensation and discretionary benefits under a defined convention. EBITDA is more relevant to a managed or multi-site operation but still requires consistent treatment of owner and central services. The specific calculation must be shown; the label does not determine what is included. See daycare SDE and EBITDA multiples and single-site versus multi-site multiples.
Reject unsupported “one-time” labels. A repair may be unusual but recurring as a category in an aging building. Legal fees may continue if the underlying dispute remains. Marketing may have been paused temporarily. An owner vehicle may be personal, or it may support food pickup and site visits. Trace the facts and ask what cost the buyer incurs instead.
Pro forma improvements belong outside historical normalized earnings unless already implemented and observed. A planned tuition increase, classroom opening, staff reduction, refinance, or purchasing saving can be modeled as an upside case with timing and cost. It should not be inserted into trailing earnings as though it occurred.
Use the balance sheet to find transaction obligations
Cash must be reconciled to bank statements and outstanding transactions. Accounts receivable need payer-level aging, subsequent collections, credits, disputes, and bad-debt policy. Prepaid expenses need contracts and benefit periods. Fixed assets need purchase records, depreciation schedules, ownership, condition, liens, and a distinction between items included in the sale and leased property.
On the liability side, inspect payables, accrued payroll and taxes, family deposits, deferred tuition, gift or credit balances, debt, leases, litigation, and amounts owed to or from owners. Old balances may be accounting errors, but they are not removed without proof. A negative liability can signal netting or classification problems that conceal the actual obligation.
Debt schedules should tie principal balances to lender statements and the general ledger. Identify liens and payoff requirements. Leases, equipment finance, vehicle obligations, merchant advances, and owner loans may not sit in one account. Counsel and the lender should determine assumption, payoff, release, and closing deliverables.
The statement date matters. A December balance sheet does not tell you the receivable, deposit, payroll, and cash position on a summer closing date. Prepare an estimated closing statement and an agreed working-capital or cut-off mechanism, then true it up from final records.
Follow cash across the operating cycle
Create a weekly cash calendar. Private tuition may collect before service, subsidy after service, and payroll every one or two weeks. Rent, insurance, food, debt service, and tax deposits land on different dates. A profitable center can still face a cash deficit when the buyer starts without seller cash or receivables but must fund care already prepaid to the seller.
Start with opening cash and list expected collections from specific sources. Then list payroll, taxes, occupancy, insurance, food, supplies, debt service, vendor catch-up, transition costs, repairs, refunds, and contingency. Run a downside case for slower agency payment, several withdrawals, overtime, or delayed merchant conversion. Working capital in child care deals explains allocation mechanics.
Cash flow from operations, investing, and financing should not be blurred. Equipment purchases and owner distributions reduce cash but mean different things. Loan proceeds raise cash but not operating earnings. Paying old payables improves the balance sheet but does not create current margin. A coherent analysis bridges accounting profit to operating cash and then to cash after capital expenditure and debt service.
Reconcile tax returns without treating them as the ledger
Obtain complete federal, state, and local returns for the operating and related entities, including schedules. Tie reported gross receipts and major expense categories to the books with a bridge for timing, tax depreciation, owner items, and reclassifications. Confirm fiscal periods and entity changes. A return for a parent entity with several operations cannot validate one site without allocation support.
Tax returns are important third-party records, but they are prepared under tax rules and may group accounts differently. They do not replace monthly management records, bank proof, payroll, or billing data. Conversely, management statements showing substantially higher revenue than filed returns require a credible documented reconciliation and professional review.
The IRS explains that a business sale is generally treated as the transfer of separate assets for tax purposes and that buyer and seller may have allocation reporting obligations. The transaction structure and allocation affect both parties differently. Accountants and attorneys should advise; the financial-statement review should preserve asset basis, depreciation, and ownership evidence so they can do so.
Build a quality-of-earnings bridge
An effective bridge starts with reported results by month and ends with a range of transferable cash flow. Show books-to-tax differences, revenue cut-off, collectability, normalized payroll, owner replacement, related-party rent, temporary programs, recurring maintenance, unusual but necessary costs, and central services. Explain every line in plain language.
Then test concentration and volatility. Show revenue by payer type, classroom, site, and large contract. Show monthly enrollment, realized tuition, receivable aging, subsidy lag, payroll, overtime, vacancies, and room closures. Earnings generated by a temporary grant or one employer contract carry a different risk from diverse, reconciled family payments.
Do not let the recast end at a higher number. A skeptical analysis can lower earnings when owner labor, under-market rent, deferred repairs, missing benefits, or uncollectible receivables are recognized. The objective is not to advocate for either side; it is to estimate the operation a buyer can actually continue.
Prepare a transaction-ready financial package
A seller should produce a financial index, monthly statements, general ledgers, tax returns, bank and merchant proof, payroll, enrollment and billing reconciliations, subsidy schedules, receivable and payable aging, debt, fixed assets, contracts, a documented recast, and a data dictionary. Explain accounting changes and preserve source exports.
A buyer should create a request register, contradiction log, recast workbook, working-capital schedule, and downside model. Questions should refer to account, period, amount, and source rather than ask broadly why expenses increased. That precision speeds seller response and produces an audit trail for lender and adviser review.
Both parties should control personal data. Use child identifiers instead of names, summarized background-check compliance instead of reports, and redacted personnel data until counsel authorizes necessary access. Financial diligence does not justify circulating medical, family, or employee information unrelated to the transaction decision.
Frequently asked questions
Which financial statements should a child care buyer request?
Request monthly profit-and-loss statements, balance sheets, general ledgers, cash-flow statements if maintained, business tax returns, bank and merchant statements, payroll registers and filings, accounts-receivable aging, accounts payable, debt schedules, fixed-asset records, and budgets. Add billing, enrollment, subsidy, and classroom records so the accounting can be reconciled to operations.
Why does the balance sheet matter in a small daycare sale?
It identifies cash, receivables, deposits, deferred revenue, payables, debt, fixed assets, owner balances, and historical errors that the income statement can hide. Even in an asset sale, those accounts reveal collection quality, pre-closing service obligations, liens, working-capital needs, and cut-off items that must be allocated in the agreement.
How should subsidy revenue be reviewed?
Match each authorization and child to attendance or service records, submitted claims, remittance detail, parent copays, bank deposits, denials, and recoupments. Separate service month from payment month and read the current state provider rules. A general-ledger total cannot show whether revenue is timely, collectible, compliant, or likely to continue after ownership changes.
What is a valid seller add-back?
A valid add-back is documented, correctly classified, and not required for the buyer's continuing operation under the assumed model. Trace it to ledger entries and invoices, explain why it will not recur, and offset any replacement cost. Owner compensation is not fully discretionary when the owner performs director, classroom, billing, sales, or facilities work.
Should financials be reviewed on cash or accrual basis?
Understand both. Cash statements show when money moved; accrual statements better match service with earned revenue and incurred expense when kept correctly. Reconcile the difference through receivables, deferred revenue, payables, payroll, and subsidy timing. Tax-basis accounting should not be mistaken for transaction working capital or recurring economic earnings.
How many years of child care financials are needed?
Three full years plus current monthly year-to-date detail is a common starting point, but the available history, seasonality, disruptions, and lender requirements may call for more. Monthly records matter because annual totals conceal tuition changes, graduation cycles, temporary grants, room closures, staffing shortages, and the exact trend entering a sale.