What to Look for In Small Business Financial Documents
One of the most important steps in buying a small business is assessing its financial strength. This means looking beyond the tax returns and examining the business’s financial statements. Most small business tax returns have been prepared in such a way to minimize taxes and do not indicate its true value drivers.
Each financial statement offers important information about the business. Combined together, these documents can give insight into the overall financial performance of a small business. They paint a picture of where the money originally came from, where it went, and where it is right now.
Key financial documents and what to look for in each of them:
1. Profit and Loss (P&L) Statements.
What It Is: Depending on the size of the business, a profit and loss statement can provide a good overview of how a business is doing over a given time period. Also known as an income statement, it shows you the revenue (top line) minus the expenses, and then the net earnings or losses (bottom line). It shows how profitable a business is by showing you gross sales, operating costs of running the business and the owner’s salary.
What to Look For: Take a look at several P&L statements to get an idea on how the business has been run. When looking at these statements, consider the risks involved with putting any more money into the business. In other words, if you do nothing different, will the business still earn a healthy profit? Keep in mind that depending on the size of the business, profit and loss statements may vary in how detailed they are. If so, you’ll need to ask the business owner the right kinds of questions to help you get the full story.
2. Cash Flow Statements.
What It Is: A cash flow statement reports the money flowing in and out of a business. It determines whether or not a business is generating cash and if it has enough cash on hand to pay expenses and purchase assets. It also shows the net increases or decrease in cash over a given period rather than absolute dollar amounts. Generally, cash flow statements are broken down into operating costs, investments and financing activities.
What to Look For: A business can be profitable but have cash flow issues, so it’s important to check these statements to assess the risks involved. It can help you understand not only how much cash is coming in, but how much cash is going out. If a business has a number of delinquent or missing payments, it could be a sign that it isn’t managed properly.
- Investments: Take a look at any purchases of any short-term or long-term investments. This can include equipment, securities, real estates and other tangible assets. You’ll want to see if there was an ROI on those investments as well.
- Financing: Look for any cash raised from bank loans to see whether or not the business has enough money to cover its daily expenses. In addition, see if the business has sold any of their assets to infuse extra money into the business. If it’s a seasonal business, you’ll want to see if it was able to cover an increase in sales.
- Operating Costs: You’ll also want to look at income minus any regular expenses to see what the net income looks like. Ideally, you’ll want to see if that gap between expenses and income is growing or if any costs associated with the daily operations are helping to grow the financials.
3. A Balance Sheet.
What It Is: A balance sheet summarizes crucial financial information and can help you determine a company’s financial strength. It lists the business assets, including what’s in its possession, such as a financed vehicle. It also shows the company’s liabilities, such as debts and outstanding credit card balances, as well as the owner’s equity, which is the company’s net worth once all the liabilities have been paid off.
What To Look For: You’ll want to look at all the business assets, liquidity ratios, liabilities, any outstanding debt, as well as how the assets are managed and how much the owner earns. A balance sheet can show you whether or not a company is able to fund its own growth without additional financing. Yet, it only gives you the financial picture of a specific date in time, whereas P&L statements look at revenue and expenses over a period of time.
How Financial Statements Can Give You a Clearer Picture About a Business
While each type of financial document shows you different information about a business, you should look at all these documents together as a whole. At the same time, you should discuss each of these documents with the owner and ask them to offer further details.
Once you have a clearer picture of how the business is doing overall, you’ll have a better idea how you stand to make money should you decide to buy it. It will also help you make smarter decisions as to what you can change in the business to grow revenue in the future. You can also begin to calculate the earning potential by valuing the business.