Buying an established company can be a great strategy for an aspiring small business owner to own their own business without starting from scratch. However, evaluating the sustainability and financial health of an existing business is crucial before signing the contract. Here are six financial documents to request and review with your accountant when buying a company.
Profit and loss statement
To understand how profitable the business is, review its revenue, expenses, net earnings, costs of operation, and the owner’s salary in a profit and loss (P&L) statement. Typically, when purchasing a business, you should request a current version of a P&L statement (no older than 180 days) to ensure you’re reviewing the most recent financial history.
To properly read a P&L statement, it’s paramount to first understand the metrics included in this document. Some important elements you will want to closely consider include the following:
- Revenue/income, or how much the business receives for its goods/services.
- Cost of goods/services, or how much it costs to produce a good or service.
- Gross profit, or the business’s total revenue minus its cost of goods and services.
- Expenses, or the cost to operate the business, including payments like salaries, leases, and office supplies.
- Net profit, or gross profit minus the business’s expenses.
[Read more: Creating a Financial Accounting Report With the Four Basic Statements]
Tax returns
You will want to request the past three to five past years of tax returns from the seller. All tax returns include the business’s date of formation, the compensation of its officers, as well as any assets and liabilities.
Depending on the tax form, you can discern different information about the business—even beyond its revenue or debt-to-income ratio. For instance, consider how much the business pays in employment tax (required for companies with W-2 employees), as well as associated self-employment taxes, which come with running your own business. Additionally, consider how much you will likely have to pay in estimated taxes per quarter.
Understanding the company's debt is especially important because it is often incorporated into the sale.
Debt disclosures
Understanding the company's debt is especially important because it is often incorporated into the sale. Generally, in sales of companies under $10 million, you can avoid debt incorporation by pursuing the sale as an asset sale instead of a stock sale. However, you may want to structure the purchase as a stock sale if, for instance, you want a particular lease or contract associated with the company. With a stock sale, debt won’t pass to you, the buyer, if the liabilities are the seller’s personal debt or if you require the seller to pay any debts at the time of sale.
Cash flow statement
A cash flow statement demonstrates how cash moves in and out of the company. This document gives you a sense of the day-to-day operations as well as a rough estimate of how the business can continue operating once you purchase it. Plus, you can see if there are any expenses you can cut by managing the company differently, potentially boosting your earnings once the sale has closed.
A business might provide a direct cash flow statement or an indirect cash flow statement. A direct cash flow statement includes specific reports of cash flow, like receipts and cash payments, while an indirect statement includes implicit reports of cash flow by adjusting net income/loss statements using balance sheet increases/decreases.
[Read more: How to Create a Financial Forecast for a Startup Business Plan]
Balance sheets
A balance sheet provides a breakdown of the business’s assets, such as cash, equipment, inventory, and property, alongside the company’s liabilities, like debts or employee wages. You can total those numbers and subtract the total liabilities from the total assets to determine the owner’s equity in the business, or the capital remaining for the business owner(s). This simple calculation can help you determine a reasonable selling price for the business as well as if the purchase is worth pursuing.
Accounts receivable and accounts payable
Accounts payable are expenses the company needs to cover financially, such as monthly expenses to suppliers. Accounts payable is considered a business liability. Accounts receivable is money the company is owed from customers, such as invoices for products or services delivered. Accounts payable is considered a business asset. Although some of the information may be present in other documents, requesting these items separately allows you to cross-reference and pin down any discrepancies.
[Read more: Accounts Payable vs. Accounts Receivable: What's the Difference?]
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