Reliable Financial Statement Crucial for Business Sales
Prior to listing their business for sale, business owners should prepare a comprehensive financial statement. In the context of business sales, a financial statement contains the last three years of historical income statements and a current balance sheet showing the company’s assets and liabilities. An income statement may be a tax return or a Profit and Loss statement (P&L), each showing the gross sales, cost of goods sold, gross profit, operating expenses, and net ordinary income of the business. A reliable financial statement allows a business broker to properly evaluate the business and to suggest a fair asking price for the business. Further, a reliable financial statement established trust (making it easier for a buyer to make an offer), accelerates the formal due diligence process, and ultimately maximizes the valuation of the business.
Adjust the Income Statement
The most recent annual income statement must be adjusted by the business broker in order to determine the owner benefit of the business. Owner benefit represents the actual economic profits derived by a working owner of the business. When it comes time to sell, business valuations are generally determined as a multiple of the annual owner benefit (not the net income appearing on an income statement). Adjusted owner benefit excludes non-cash charges taken on the income statement such as depreciation as well as debt servicing costs. The resulting EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) must be further adjusted by adding back the owner’s wages, personal expenses of the owner that flows through the income statement, and any other costs that would not be borne by the buyer in order to obtain the owner benefit.
Itemize Owner-Related Wages
- When compiling their financial statement, business owners should itemize any salary expenses for the owner and for any of the owner’s family members.
- This way the business broker will be able to determine the extent to which such salaries should be added back to owner benefit.
- The owner’s salary is almost always noted as a separate category within a tax return or profit and loss statement as “Officer’s Salary.”
- Salaries for the owner’s spouse (if not an Officer) or for other families members are contained in the ‘salaries and wages’ expense category along with other employees.
- If the owner’s spouse or other family members are absentee from the business, then their salaries entirely belong in adjusted owner benefit (since the buyer would not need to pay them to maintain the current business operations).
- Otherwise their replacement costs should be deducted from their gross wages.
- The difference between their salaries and replacement costs (or the net savings to the buyer) should then be added back to adjusted owner benefit.
- A working owner’s salary is generally added back to adjusted owner benefit unless the owner has unique and special skills which a buyer would not be reasonably expected to replicate.
- When such situations arise, the replacement cost of the owner should be estimated to the best extent possible, and the difference between the owner’s salary and their replacement cost is added back to adjusted owner benefit.
Itemize Personal Expenses of Owner
A critical aspect of adjusting the income statement is identifying personal expenses of the owner (or other irregular expenses) that are expensed in the income statement. Once identified and matched with the correct expense category, the income statement is adjusted by adding back such expenses to owner benefit. Common examples are personal auto or health insurance expenses of the owner that flow through the ‘insurance’ expense category, personal meals and entertainment expenses that flow through the ‘meals and entertainment’ expense category, personal expenses for supplies that flow through the ‘cost of goods sold’ expense category, and personal legal expenses that flow through the ‘legal and professional’ expense category. Most buyers will verify the personal expenses as legitimate ‘add-backs’ during the formal due diligence process.
Balance Sheet and Equipment List
Most business owners obtain their balance sheet on Quickbooks or by asking their accountant. A balance sheet lists the assets of a business (such as accounts receivable, cash, inventory, and depreciated equipment value) and liabilities (such as debt and account payables). Cash, liabilities, and accounts receivable are not typically transferred to the buyer in small business sales, and the depreciated equipment value shown on a balance sheet may not conform to reality. For these reasons, it is often more useful for potential buyers to receive a supplemental equipment list as a part of the balance sheet. An equipment list highlights each major tangible piece of equipment (such as vehicles, machinery, and office furniture) included in the sale along with each item’s current approximate value. This way, buyers will receive an accurate report on what is included in the sale, as well as an overall balance sheet.
Prior to listing or selling their business, a business owner should take the time to compile an accurate financial statement. The complexity of a financial statement depends upon the size and scope of the business. Every financial statement should have a properly adjusted income statement for the last three years, with emphasis placed on the most recent annual tax return or profit and loss report. For businesses which carry a large amount of equipment, a balance sheet supplemented by an equipment list should also be a part of the financial statement.
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