The Business Our Client Wanted to Buy Looked Profitable. Then We Reviewed the Books.
By ProfitWise - a Visa Business Plans company
One of our clients was considering buying an established business that appeared to be doing well.
The seller provided financial statements showing solid revenue and healthy profit, and those numbers were naturally a key part of how our client evaluated the opportunity and the asking price.
Before moving forward, he asked us to review the financials.
As we started going through the books, we found problems.
Some transactions were categorized incorrectly, certain expenses weren’t reflected as we expected, and several numbers needed further explanation before we were comfortable relying on the profit shown on the financial statements.
By the time we worked through the issues, the financial picture looked different from the one our client had initially been given.
The business was still generating revenue. It was still operating. It might even still have been worth buying.
But it wasn’t as profitable as the original financial statements made it appear.
A P&L Is Only as Reliable as the Bookkeeping Behind It
Buyers often receive a profit-and-loss statement and naturally focus on the bottom line.
If the business generated $1.5 million in revenue and shows $250,000 in profit, those numbers quickly become part of the acquisition decision. The buyer starts thinking about the purchase price, financing, and how much income the business could potentially provide after the acquisition.
The problem is that a financial statement doesn’t independently verify the information behind it.
If expenses are categorized incorrectly, transactions are missing, accounts aren’t reconciled properly, or the books are maintained inconsistently, the profit at the bottom of the statement may not reflect how the business is actually performing.
That’s why we wanted to understand the numbers behind the numbers before our client relied on them.
We Weren’t Looking for Something Wrong. We Were Trying to Understand What He Was Buying.
There is an important distinction here.
Finding problems in the bookkeeping doesn’t automatically mean the seller was trying to misrepresent the business.
Small-business books can become messy for many reasons. The owner may have done the bookkeeping personally, different people may have handled it over the years, or transactions may have been recorded incorrectly.
Our concern was not determining why the errors occurred.
Our client was preparing to invest a substantial amount of money based partly on the financial performance of the company, so we needed to understand what that performance actually was.
That meant questioning anything that didn’t make sense and asking for additional information when the financial statements didn’t tell the entire story.
A Difference in Profit Can Change the Entire Acquisition
Suppose a business appears to generate $250,000 in annual profit.
The buyer may use that figure to determine how much the company is worth, how much debt it can support, and how much income might remain after making the acquisition loan payments.
If a closer review shows that the business is actually generating closer to $170,000, the buyer is now evaluating a very different investment.
The purchase price that initially seemed reasonable may deserve another look. The proposed loan payments may consume a much larger percentage of the company’s cash flow, and the amount available to compensate the new owner could be substantially lower than expected.
An $80,000 difference in annual earnings isn’t simply an accounting correction. It can change whether the economics of the entire transaction work for the buyer.
We Also Needed to Separate Bookkeeping Problems From the Business Itself
Incorrect financials don’t necessarily mean the underlying company is a poor investment.
In fact, correcting the books may reveal a business that still has many attractive qualities.
The difference is that our client can now evaluate the opportunity using financial information that more accurately reflects what has been happening.
That might lead him to proceed with the acquisition as planned. It could give him information that becomes relevant when negotiating the purchase price or structure. In some situations, the revised numbers may show that the business cannot comfortably support the financing required for the acquisition.
Those are very different outcomes, and the buyer needs reliable financial information to evaluate them.
The Asking Price Isn’t the Only Number We Want to Test
Once we have a clearer understanding of historical performance, we can also assess what the business may look like under our client’s ownership.
The seller may perform responsibilities that our client intends to hire someone else to handle. The buyer may have acquisition debt that the current owner doesn’t have, or the business may need additional working capital after closing.
We can incorporate those changes and determine how much cash the company could realistically generate once our client owns it.
Through our Fractional CFO work, we can also test what happens if revenue declines temporarily after the transition, payroll increases or the company encounters expenses the buyer wasn’t expecting.
This gives our client a financial picture built around the business he is actually considering buying, not simply the version reflected in the seller’s historical P&L.
Buying a Business Means Buying Its Financial Reality Too
A buyer can tour the facility, meet employees, learn about the customers and understand how the company operates.
But a significant part of what determines the value of an established business is its ability to generate income.
Our client was preparing to pay for that earning capacity, which is why we wanted to know that the financial information supporting it was reliable.
In this case, reviewing the books changed our understanding of how profitable the company actually was. That didn’t automatically make the business a bad investment, but it gave our client a very different set of numbers to use when deciding what the opportunity was worth to him.
When you’re considering investing a substantial amount of money in an existing business, finding those differences before the purchase gives you the opportunity to evaluate them.
Finding them after you own the company is a very different situation.
