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.
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, cash flow statements, and balance sheets 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. See the first part of this article for more details.
Still, you’ll also want more information about their tax filings and balance sheet. See the second part of this article for more details.
In part 3 of this series of articles an explanation on the important elements of the P&L, the important ratios and how to combine the numbers to extract more information from the financial reports.
What to Look for in Financial Documents
The documents you get are only as useful as your ability to review them for the right information. This means piecing together details across different records to understand better how well the business is doing.
Revenue
Revenue, also known as gross sales, is the amount of money a company brings in from sales during a defined period. This is where everything begins: the money a company brings in dictates how it spends, its profitability, and more. You can usually find revenue at the top of an income statement.
Expenses
Expenses are costs that a company incurs during its regular course of business. There are various forms of business expenses, given the breadth of what the term covers. In general, there are five types of expenses:
Cost of Goods Sold (COGS): Expenses related to the purchase and manufacture of products (a grocery store’s inventory could be considered a COGS expense, for example).
Operating Expenses: Money spent to pay for everyday costs related to running a business. These could be anything from online marketing campaigns to electricity bills.
Non-Operating Expenses: Expenses that are not directly related to the core operations of a business. These expenses are usually incidental or infrequent in nature.
Extraordinary Expenses: Expenses that are unexpected or unusual expenses that are not part of a company's regular operating expenses. These include natural disasters and unexpected events that require significant repairs or replacements, legal settlements, or a major change in business operations requiring significant restructuring costs.
Financial Expenses: A business's costs related to borrowing and managing its financial resources. This may include interest payments on loans, fees for financial services, and expenses associated with managing investments or assets.
Financial Performance
Review the expense section of the income statement to understand the business's financial performance and cost structure. Look for any significant changes in expenses over time.
Profitability: A company's ability to generate earnings. It can be influenced by revenue and operating expenses, among other things.
Assets and Liabilities: Assets are resources that a company owns or controls that have economic value and are expected to provide a future benefit. On the other hand, liabilities are obligations or debts that a company owes to others and are expected to be settled by providing assets, services, or payments.
Cash Flow: The amount of cash or cash equivalents that flow in and out of a business over time — usually a month, quarter or year. It takes into account the inflows and outflows of cash related to a company's operations, investments, and financing activities.
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