Three Financial Reports You Need to Look at When Buying a Business
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The following article was originally written by Melanie Smollen for BizBuySell.
When you buy an existing business vs. doing a start-up, it’s an exciting opportunity to leverage an established brand and pay yourself on day one, but how can you be sure you are buying a good business? There are a host of things to pay attention to, and one of the most important parts of your research will be to analyze the financials. Business financials will tell you a story about how viable the business is and if it’s making money. They will also reveal any red flags or inconsistencies that may exist. At a minimum, you want to see the last three years of financials so you can see how a business has performed over time.
While there are multiple financial reports you can look at to learn whether or not a business is financially healthy, some will tell you more than others, and if you aren’t familiar with what you need to pay attention to, that process can be quite daunting.
Let’s take a closer look at three financial reports you should analyze before buying a business:
1. Income Statement
An income statement (also known as a Profit & Loss) is a financial report that represents a time period (usually a year) and reveals how much money a business has taken in, what they spend, and what’s leftover – the net income or net loss. A financially healthy business should turn a consistent profit after all the expenses are taken care of. If the business isn’t consistently seeing a profit, you need to dig into why. Sometimes it’s because the business isn’t selling enough of its product or service, other times the pricing is out of whack, or the strategy just isn’t viable. Regardless of why, fluctuations in profit can make or break a business. Also, beware of a seller who explains away losses by talking about how much potential a business has; if it’s possible, why haven’t they done it already?
2. Balance Sheet
A balance sheet is the “state of the union” for a business. It tells you what a business owns and owes, and the difference between the two is called equity.
A balance sheet is run as of a specific date and provides a snapshot in time. There are three main parts, and each part tells you something different:
- Assets: What a business owns includes things like cash, equipment and vehicles, accounts receivable, etc. Look to see what a business can convert into cash relatively quickly and if it has the means to stay afloat without going into debt.
- Liabilities: What a business owes, such as loans, credit card balances, payroll taxes, accounts payable, etc. In a typical “main street” asset sale, a buyer won’t assume a seller’s debt; it will be paid off from the proceeds of the sale at closing.
- Equity: Simply put, equity represents the owner’s interest in the assets of the company, net of its liabilities.
3. Cash Flow Statement
A cash flow statement provides a more detailed look at the money that is coming into and going out of a business. Typically, this report is broken into three sections:
- Operating activities: Refers to the primary activities that generate revenue and expenses. When a business sells something, it receives money into the business; then it has expenses associated with what it sells (fixed and variable).
- Investing activities: Cash generated by selling assets and the money spent from buying assets. This often includes things like property and equipment paid for in cash.
- Financing activities: Any activity that involves providing funds to a business (debt or equity) is categorized as a financing activity.
A financially healthy cash flow statement will show over time that a business generates more money than it spends and won’t just have enough cash flow to pay its expenses, but will also generate enough income to purchase assets and make good growth decisions.
There is a lot involved in buying an existing business, and understanding the financials is only one part. If you are planning to buy a business, there is usually a period called “due diligence” where you can inspect a business’ financials, records, contracts, etc. and make sure you are comfortable with what you see. By working with a team of professional advisors – generally an attorney, accountant, and a business broker/merger and acquisition advisor – you can feel confident that you have properly analyzed all the components of a business before you buy it.