When it comes time to sell your business, the condition of your financial statements can play a significant role in how your business is perceived by potential buyers and in how much a buyer is willing to pay. If you're thinking of selling your company, it makes sense to take a closer look at the quality of your financial statements. Even if you aren't considering selling, improving the quality of your financial statements will yield better information to manage your company.
How can good financial statements benefit you when you sell?
- Accurate financial statements provide a sound basis for valuing your business and analyzing the results of operations.
- It's easier to build your case for the value you believe the company is worth when the integrity of your financial data is sound.
- You will be able to easily identify items that should not be included in the sales price, including add-backs such as entrepreneurial expenses and one-time items such as
- Timely, accurate, well-organized financial statements present your business to prospective buyers effectively; buyers won't have to ask a lot of questions to understand the results of operations and your financial position.
- You will be better able to explain changes in the business over time if your controller reviews financial results and investigates unusual items each month.
- You will spend less money on accounting and consulting fees before, during and after the sale because quality financial data doesn't require a lot of verification and review.
- Accurate financial statements reduce the opportunity for a buyer to work the price down during the due diligence process.
Timing is everything
When you close your monthly financial statements plays a key role in the accuracy of their information. If you don't cut off each month at the right time, you may have significant fluctuations in your gross margin. Your sales may be cut off at the right time each month, but perhaps your costs aren't, or vice versa. This could cause your margins to fluctuate as much as 5% to 10% of sales from month to month, even though you're selling the same product. If you can't explain these fluctuations because you're not tracking expenses well, buyers will be less likely to trust the information in your financial statements and less willing to pay a high dollar for your business.
Looking beyond the bottom line to find true profitability
Savvy buyers are looking not only at your bottom line, but at the profitability of your operations. Two similar businesses that drop the same amount to the bottom line at a given level of sales are not necessarily equal in value if one has a higher gross margin than the other and turns its inventory faster.
Example: Company A and Company B both make widgets and have sales of $100,000 and net income of $5,000. If Company A has a gross profit of $30,000 and Company B's gross profit is only $25,000, Company A is worth more to a buyer because it manufactures its product more cost-effectively and will produce more profit with an increase in sales.
A buyer's decision is going to be based largely on the information you provide on your financial statements. If that information, particularly in regard to cost accounting, is not prepared accurately, you could be shortchanging yourself by undervaluing your business.
Is inaccurate cost accounting undervaluing your business?
Many companies do not do an effective job of cost accounting. If you're not costing your product correctly, your gross profit numbers may not be correct.
Example: Company B above was erroneously including R&D and administrative expenses in its cost of goods sold (COGS) when it should have included only the costs of material, labor and overhead directly related to manufacturing of a product. This resulted in overstating the company's COGS thus lowering the gross profit, and reducing the value to a potential buyer. By costing its inventory correctly, Company B would have shown a gross margin of $35,000 rather than $25,000, surpassing the $30,000 gross margin of Company A.
What are some common mistakes in financial statements?
Here are some factors that can detract from the value of your financial statements:
- Not performing bank reconciliations and booking the entries monthly;
- Not accurately accruing revenues and expenses and the related assets and liabilities;
- Not identifying and liquidating slow-moving or excessive inventory;
- Not setting up your costing system to accurately cost different products or lines.
Overstated or understated costs can lead to bad business decisions and underpricing or over-pricing your product;
- Not having proper controls to ensure accurate and timely processing of all items affecting the financial statements;
- Not reconciling prepaid items, other assets or accrued liabilities monthly, resulting in overstating or understating net income and working capital;
- Cutting checks and holding them, understating cash and accounts payable;
- Not coding expenses to the correct departments on the income statement, which can lead to understating or overstating COGS;
- Not having an easily navigated layout for the income statement and balance sheet, making it difficult to interpret data;
- Not having a good back-up or foundation for changes made in the year or two prior to sale; and
- Not having a good accounting firm, or changing accountants immediately prior to sale.
How can accurate financial data help when you sell your business?
- Streamlining valuation. Accurate financial statements can ease the valuation process and save you money. To value your business, your financial advisor will compare your financial statements, inventory turns, gross margins, how fast you're turning receivables, and EBITDA (earnings before interest, taxes, depreciation and amortization) to other companies in the marketplace. If the information in your financial statements is not accurate, not laid out in a way that makes it easy to compare your information to the marketplace, or your data is not reliable, valuation becomes more difficult. Your advisor will have to spend more time, and charge you more money, to correct inaccurate information or dig into why certain costs or margins are showing great fluctuations because they weren't prepared correctly.
- Making it easy to answer buyers' questions. When potential buyers start asking questions and digging into your financials, you will need to give them more detailed information, such as a breakdown of COGS, as well as sales, marketing, R&D and general administrative cost details. Having accurate, well-laid-out financial statements will make it easy for you to answer these questions. Potential buyers will then conduct their own valuation to determine how much they're willing to pay.
- Confirming your company's value during due diligence. After the buyer has submitted an offer and letter of intent, he will look through your books to verify that the information you have presented is accurate. If he discovers that your method of inventory accounting was not correct, and the sales price was based in part on the value of your inventory, the buyer will try to lower the purchase price.
- Avoiding cash outlays after closing the sale. Even when the sale is closed, there are still financial details to be resolved. Before the sale, the buyer and seller agree on targets, such as a working-capital target, as of the date of closing. Accurate financial statements will make it easier for you to calculate a more accurate working-capital target. Improper accounting practices could result in missing items that should be included in that number. After closing, the buyer's accountant will prepare closing statements based on the rules in the closing agreement. If the actual working capital on the date of closing is lower than the target, you will owe the buyer the difference, and vice versa.