What to Look For in Financial Statements When Buying a Business

Investing your time and money into buying an existing business is not something to take lightly. Investment best practices dictate that aspiring business owners should seek out companies for sale with strong balance sheets, solid earnings, and positive cash flows. Knowing what to look for in financial statements will help you identify if the business you’re interested in buying is a positive investment.

Three Core Financial Performance Reports You Need to Review

Before you begin to analyze the financial position of the business you would like to buy, it’s important to learn about the company, the products or services it sells, and the industry in which it operates. However, when you’re ready to look at a company’s finances, you should look at these three sets of financial information commonly used to evaluate business value: income statement, balance sheet, and cash flow statement. We recommend going through these statements with a trusted accountant or business broker who can interpret and explain the financial jargon for you.

1. Income Statement

The income statement, also known as a profit and loss statement, is a crucial annual report that public companies are legally required to submit to the Securities and Exchange Committee (SEC). Companies that do not publicly trade on the stock market do not have to submit their income report to the SEC, but that doesn’t make it any less important for you to request to understand their finances as a buyer. Revenue, expenses, gains, and losses are four critical factors in this report that help us actualize a business’s bottom line.

A simple way to calculate the bottom line (net income) is to subtract a business’s operating expenses, like the cost of goods sold, gross profits, depreciation expenses, and income taxes, from its top line (gross revenue), including future incoming cash like sales made with credit. You don’t have to immediately discard a business if it’s not profitable yet. If it shows a clear path to profitability, you may be in the clear but you should consult with your business broker or advisor first.

It’s important to note that the income statement can also give us a window into its operations, how it is managed, which sectors are underperforming, and how it stacks up against its competitors.

2. Balance Sheet

The balance sheet shows a snapshot of a business’s financial condition at any given period of time. It details what the business owns (current assets), what the company owes (liabilities), and the difference between the two (shareholders’ equity). The company’s assets should always equal the liabilities plus the shareholders’ equity, hence the name “balance sheet.” In other words, the business should have more current assets than current liabilities. If there is a gap, compare this period’s balance sheet to older reports to see if there are any trends.

This document also gives you insights into a business’s liquidity ratio. Their current ratio shows us if the owner has enough cash to cover outstanding debts and cash flows in the short term without raising additional capital.

You should also look at the business’s accounts receivable as there may be customers or clients who owe the business money. If this is the case, be sure to clarify whether the current owner will balance the accounts before you buy the business or if you will be responsible for collecting those payments.

3. Cash Flow Statement

A statement of cash flow describes the flow of cash and cash equivalents coming to and from the business. A general rule of thumb is that a company should generate enough cash to pay expenses and purchase assets. Analyzing a company’s cash flow helps us understand where its money is coming from and how it is spent. The cash flow statement should outline cash from operating, investing, and financing activities. You can even use current and previous years’ reports to predict future cash flow. Note that a business can be profitable and still have cash flow issues.

We always suggest analyzing the income statement, balance sheet, and cash flow statement side by side, comparing and noting any discrepancies you may find. But interpreting a business’s financial health takes a lot of work, and you may not always be able to understand what you’re looking at. No matter what stage of the buyers’ journey you’re in, a business broker is a worthwhile investment. Let us help! Find a Sunbelt office near you for the support you need to reach a successful transaction.