Mind Your Balance Sheet
When evaluating companies, owners typically have a good sense of their profit and loss statement and want to make it a focal point of conversation. However, they don’t seem to grasp the importance of the company’s balance sheet.
The lack of understanding of one’s balance sheet and the poor quality of the information on balance sheets is cause for concern and can dramatically impact a transaction. Below, I explore several issues that can occur in a deal if the balance sheet is ignored by a business owner.
1) Too much working capital in deal: When buyers make an offer on a business, it identifies the assets and liabilities that are being assumed in the transaction. An informed buyer will make an offer that includes enough working capital (current assets – current liabilities) that allows the business to continue operating without disruption. If the business has not historically managed its working capital correctly, a buyer may believe that the business needs more working capital than it does in reality. An example of this may be a business keeping more inventory than necessary in stock, or letting accounts receivable remain outstanding for longer than agreed upon terms. Should a buyer negotiate excess working capital in a transaction, money is being left on the table for the seller.
2) Net income is opinion. Cash flow is fact: The income that a business generates is not necessarily indicative of its performance. For example, a business using cash accounting may be increasing Y/Y, but if accounts receivable is increasing, revenue may be understated (on an accrual basis), or if accounts payable decreases, expenses may be overstated (on an accrual basis). The balance sheet is the best indicator of the cash generation ability of the business because it allows the business owner to measure the changes in business performance from one period to another.
3) Not taking end of year inventory: Many balance sheets I look at have an inventory that is constant from one period to the next. Of course, it’s laborious to take inventory in a 20,000 foot warehouse or when a business has thousands of SKUs. However, the end of year inventory number is a key determinant in a company’s cost of goods sold. Should a buyer make an offer and find that inventory is overstated on a balance sheet, that implies that cost of goods sold is understated on a profit and loss statement, thus a business is making less money than the seller is portraying. It’s an awful experience for a seller to have a deal fall apart in diligence because the buyer made an offer and later renegotiates or reneges due to incorrect information being provided.
4) Rebate of prepaid expenses and prepaid revenue: The closing of every transaction has adjustments. Some bills are prepaid and the benefit is going to be gained by the buyer. This prepaid expense should be an asset on the balance sheet. Some clients pay cash before a project has started and the buyer will need to perform a service. This prepaid revenue should be a liability on the balance sheet. When negotiating a transaction, the buyer and seller need to identify the flow of prepaids to make sure they are negotiated, and ultimately need a mechanism to measure them upon the closing of a transaction so that each party is recognizing the revenue and expenses that belong to them.
5) Tax consequences in a resale: When a business is sold, the total purchase price is split up into categories, i.e., furniture, fixtures & equipment, goodwill, covenant not to compete, etc. This process is known as the allocation of purchase price. Each category is taxed differently, so optimizing the allocation can potentially result in significant tax savings to the seller. However, just because a tax rate in one category is higher than another does not mean that category is bad if the seller already has a tax basis in the category. A seller’s tax basis is changing continuously as assets are purchased, depreciated, and amortized, and the best way to keep track of the basis for each category is on the balance sheet. Remember, it’s not just important to maximize what you get, but what you keep.
6) In stock deal, the buyer is purchasing balance sheet: If you recall from prior articles, buyers are often structuring their transactions as asset deals, whereby they are acquiring all assets of the business, but not the corporate entity itself. Thus, they are not acquiring your balance sheet. However, for deals that are structured as stock transactions, the entity continues to operate as if nothing changed, such that the balance sheet is acquired. Buyers are weary of purchasing unknown liabilities and will use heavy legal representations to protect themselves if agreements are structured this way. The cleaner and more accurate the balance sheet, the higher probability a buyer will consider this deal structure and that a seller will keep from breaching legal representations.
This is by no means an exhaustive list of issues, but identifies the importance of one of the financial statements that are oft ignored by the small business owners. Consult with your bookkeeper or CPA to get this piece of your financial house in order.