How to Evaluate Small Business Financials

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. 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 various financial documents, 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.

Tax Returns

Tax returns summarize the business's taxable income, deductions, and tax liabilities, offering insight into the company's profitability and financial stability. By examining a business's tax returns, a buyer can evaluate its cash flow, identify potential tax issues or liabilities, and determine the level of risk associated with acquiring the company. 

The information in tax returns can also help buyers negotiate the purchase price and understand the tax consequences of acquiring the business.

Accounts Receivable and Accounts Payable Reports

Accounts receivable and accounts payable reports provide a snapshot of a company's outstanding invoices and bills owed to suppliers. Accounts receivable reports show the amounts that customers owe to the business for goods or services that have been delivered but not yet paid for, while accounts payable reports show the amounts that the business owes to suppliers for goods or services that have been received but not yet paid for. 

These reports help businesses keep track of their cash flow, manage their financial obligations, and ensure that they  collect payments and pay their bills on time. By analyzing these reports, businesses can identify areas where they need to improve their cash management practices and take appropriate actions to address any issues.

Inventory Reports

Inventory reports show the levels and the valuation of a company’s goods. These reports are essential for businesses to manage their inventory efficiently, optimize their stock levels, and avoid stock-outs or overstocking.

By analyzing inventory reports, businesses can identify trends in their inventory levels and adjust their purchasing and stocking practices accordingly. For example, they may notice that certain items are selling quickly and modify their orders to ensure they don't run out of stock.

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.

Calculate Financial Ratios

Financial ratios are a valuable tool for evaluating a business's financial health. Here are some of the most important ratios to calculate:

• Gross Profit Margin: Measures the business's profitability by comparing its gross profit to its revenue. A higher gross profit margin indicates better profitability.
• Net Profit Margin: Measures the business's profitability by comparing its net income to its revenue. A higher net profit margin indicates better profitability.
• Current Ratio: Measures the business's ability to pay its short-term liabilities by comparing its current assets to its current liabilities. A higher current ratio indicates better liquidity.
• Debt-to-Equity Ratio: Measures the business's leverage by comparing its total debt to its total equity. A lower debt-to-equity ratio indicates better financial stability.
• Inventory Turnover Ratio: Measures the business's efficiency by comparing its cost of goods sold to its average inventory. A higher inventory turnover ratio indicates better efficiency.

Look for Red Flags

When reviewing small business financials, it’s important to look for red flags that may indicate potential issues with the business. Here are some common red flags to watch out for:

• High Debt Levels: If the business has a high level of debt compared to its equity, it may indicate financial instability and difficulty servicing debt obligations.
• Declining Revenue or Profitability: If the business has experienced a decline in revenue or profitability over time, it could suggest underlying issues with the business model or market conditions.
• Poor Cash Flow: If the business has consistently negative cash flow or struggles to pay its bills on time, it might indicate underlying issues with its operations or management.
• Overvalued Inventory: If the business has an inventory valuation significantly higher than its cost of goods sold, there might be an overstocking issue or trouble selling inventory.
• Late Tax Payments: If the business has a history of late tax payments, it may indicate poor financial management or a lack of cash flow.

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.