Are you ready for a crash course?
If you’re in the market to buy a business, a major part of your acquisition will be carefully reviewing the finest financial details of your target company.
Profit and loss (P&L) statements (1), cash flow statements (2), and balance sheets (3) are all critical documents you’ll want to review when vetting a company up for sale.
Each tells an important financial story and provides vital stats on a business’s health, giving you a sense of its true value and longevity. These three documents are a core piece of your due diligence.
Still, you’ll also want more information about their tax filings and earnings before interest, taxes, depreciation, and amortization (EBITDA).
Here's an explanation of these financial documents.
In the next articles we show you how to calculate key indicators, and what red flags you should look for.
The Role of Financial Documents
Sizing up a good business acquisition or investment opportunity is a blend of both art and science. There are plenty of elements for which you should rely on your gut and intuition, of course — for instance, sizing up whether the industry is suitable for your experience or if the quality of the product feels substantial and right for the target customer base.
The other piece, however, is based on hard numbers and rooted in financial documents, ratios, and formulas.
These data give you a better understanding of the company's operations and are crucial to defining a company's track record and potential trajectory.
Income Statement or Profit and Loss (P&L)
An income statement, also known as a profit and loss (P&L), can give an overview of a business's performance over a given period, depending on its size. Income statements outline revenues, expenses, and net income over a specific period (monthly, quarterly, or annually).
It displays the revenue (top line) minus expenses, resulting in net earnings or losses (bottom line), which indicates the business's profitability by revealing gross sales, operating costs, and owner's salary. Additionally, the income statement is the basis for determining the seller's discretionary earnings (SDE), which is crucial for business valuation.
Balance Sheet
The balance sheet presents a summary of what the company owns (assets), what it owes (liabilities), and what remains after all debts are paid (equity) at the specified point in time — often, the end of the fiscal year. This information is crucial for investors, creditors, and other stakeholders.
Cash Flow Statement
A cash flow statement is a financial report that shows the cash coming in and moving out of a business, typically on a monthly, quarterly, or annual basis. The cash flow statement tracks the inflows and outflows of cash from the company's operating, investing, and financing activities.
This statement provides insights into the company's ability to generate cash, manage cash flows, and meet its financial obligations. By analyzing the cash flow statement, investors, creditors, and other stakeholders can determine the company's liquidity, financial health, and ability to invest in future growth opportunities.
Ask Questions and Seek Expert Advice
It’s important to ask questions and seek expert advice when reviewing small business financials. Ask the seller for clarification on any issues or discrepancies that you identify. You may also want to ask for advice from a business broker, accountant, or another financial professional who can provide additional insights and guidance.
Reviewing small business financials is an essential step in the process of purchasing a business. By obtaining and analyzing the necessary financial documents, calculating key financial ratios, and looking for red flags, prospective buyers can fully understand the business's financial health and decide whether to proceed with the purchase. Remember to seek expert advice and ask questions to ensure a thorough review of the financials.
This article is reposted, with permission, from DealStream.
May 1, 2023