Whether you’re buying or selling a business, understanding financial statements is crucial. Being able to adequately evaluate financial statements gives you a direct window into the financial health of a business.
Many an inexperienced investor has fallen into trouble because they missed something critical in the finances before the sale! And many a business owner has lost out on profits because they didn’t understand the true worth of their business.
Understanding financial statements will allow you to form a solid valuation of what you think the business is worth, so you can ask for a fair price for your business or pitch your offer to the seller appropriately.
There’s just one problem…
Fully understanding financial statements is a skill – and it’s one that most business owners just don’t have.
Not everyone has a financial background. And that means buyers get blinded by the numbers and important information gets missed. And sellers get taken for a ride and manipulated.
In this blog, we’ll dive into the various elements of financial statements so that you can feel more comfortable reading them and really understand what they’re telling you…
What Exactly Are The Financial Statements?
A business seller should have the financial statements of their business readily available. They should be well organised, thorough and accurate. While it may be tempting to “miss out” the odd bit, it’s not worth the seller’s risk to withhold information. It almost always comes out in the wash and can land you in hot water when you’re found out.
A buyer will want to see the financial statements quite early on in the process – long before you get to the due diligence stage. They will want to dig deep into the finances of the business to establish just how stable and profitable it really is before they move forward with the next stage of a purchase.
The financial statements consist of the following elements:
- Balance sheet
- Profit and loss accounts
- Cash flow statement
Included alongside the financial statements should be essential notes explaining how the numbers in the statements were arrived at and providing intricate information, such as that related to asset depreciation, interest and bank loans.
And finally, the management accounts. A buyer should expect to be provided with 3 years’ worth of them, as well as the current period AND a forecast for the next 12 months.
Management accounts are financial reports that track performance across different areas of a business. They are generally used quarterly, monthly or even weekly within management teams to inform important business decisions with real-life data.
Consider all of the above…
Alone, each element does not hold enough value for a buyer to assess the financial health of the business. Let alone base a valuation. It’s when reviewed together that the documents give the buyer a complete picture.
For now, though, let’s take it one at a time.
The Balance Sheet
The balance sheet is the summary of the financial balances of the business at a specific point in time. It details what came in and what went out during the preceding period, and reports on the company’s assets, liabilities and shareholder equity.
The balance sheet also gives the buyer what they need to work out rates of return and decipher the real-time mix of debt and equity that is financing the operation.
To do this, the buyer can use the accounting equation: Assets = Liabilities + Owners’ Equity.
Lost? Don’t go! It’s just business talk…
You’ll need to pick it up if you’re going to adequately understand and assess financial statements.
In plain English:
- Assets are anything owned by a company that holds monetary value
- The term liabilities refers to legal debts the company owes to third-party creditors (such as suppliers and landlords).
- And if you sold all of the assets and paid all of the debts of the company, you’d be left with the Owners’ Equity.
Profit And Loss Account
The profit and loss account, or P&L, is a financial statement that summarises the revenue, costs and expenses incurred during a specified period of time. The account is usually shared as part of quarterly and annual reports.
Let’s continue keeping it simple with some clear definitions. Your average P&L account will report on the following:
- Sales: The total amount of money coming in through sales.
- Cost of sales: The accumulated total of all costs used to create a product or service sold.
- Gross profit: Total sales minus the total cost of sales.
- Overheads: Operating expenses such as wages, rent, business rates, marketing etc.
- Net profit: Gross profit minus overheads.
Some profit and loss accounts include additional information such as how much corporation tax will be due but this isn’t standard practice.
The P&L focuses a lot of information in one place and is a very valuable document. Buyers reviewing a company’s P&L can understand how profitable the business is as well as wider financial trends, such as when costs are higher and lower.
You can also use a profit and loss account to help calculate a company’s EBITDA – a very useful process for working out the value of a business. You can read more about how to value a business in our previous blog post here…
The Cash Flow Statement
The cash flow statement summarises the movement of cash going in and out of the business over a certain period, known as the accounting period. It gives a clear view of the company’s ability to function, where money is coming from and how it’s being spent, including data on admin expenses, depreciation, interest and tax.
The CFS comprises of three main parts:
- Cash flow from operating activities (how much cash is generated from the company’s products or services)
- Cash flow from investing activities (mainly relating to changes in equipment, assets or investments)
- Cash from financing activities (detailing cash flow from both equity and debt financing
The CFS paints a picture of the types of business activities that make money. Though it is not proof of profit, a positive cash flow demonstrates a business’s financial stability.
How It All Fits Together
Can you see how it all fits together? The financial statements complement each other.
Analysing the balance sheet, the P&L and the CFS together means you can assess the full picture of a company’s financial health.
Worried you’ll miss something? Not feeling too hot on financial jargon? You’re in for a lot of it I’m afraid – unless you enlist some help.
Book a call with The Business Consultant and let him guide you through the process.