Reviewing Financials

It can be difficult to cultivate great small business lessons from multi-billion dollar companies or executives however, one of the greatest stories I ever heard about financial statements was Michael Eisner admitting that he had no idea how to read a Balance Sheet when he first became the CEO of Disney in 1984. At that time, Disney had Revenues of $1.7 billion and an enterprise value of $3 billion. I guess he learned pretty quickly since their revenues were over $30 billion when he left twenty years later and had an enterprise value of more than $60 billion.

Not bad!

Michael Eisner propelled Disney’s growth during his tenure and no matter how old the story may be, the lesson is always applicable. He was a very talented entertainment executive, and learning how to read financial statements was not the sole reason for the phenomenal growth at Disney, but rest assured, he could not have negotiated the deals he did, or leverage the Disney assets so favorably, if he had not become an expert on the financial side of running a business.

The acquisition of this “big business’ skill set is undoubtedly one that EVERY buyer must be in place or be acquired when buying a business, regardless of the size company being considered.

I have been asked countless times by prospective business buyers what is the single most important consideration they should make when looking to purchase a company and my answer has always remained the same: “Identify with absolute certainty what type of business is right for you.” A very close second would be to become an expert on analyzing financials.

Regardless of how the other components of any business for sale measure up, most often a buyer’s final decision to either buy or walk will be based upon to the historical financials of the business, which in turn of course is a fundamental component of the overall valuation/purchase price and the future projections.

The other important issue here is how frequently the actual financials do not prove out once an in-depth review is conducted. For me, this is a terribly frustrating situation and that is why I always get to the numbers quickly (as I have described in a prior post). If a buyer does not know how to tear apart financial statements, they will get burned…that I guarantee.

The good thing about financial statements is they follow a general pattern regardless of the business, as long as they are properly documented. An effective analysis goes way beyond simply “looking over” the P & L, Balance Sheet and even the tax return. To effectively review a business, a buyer must dig into the numbers and truly understand them. It is important to get a handle on the questionable figures (and there are usually plenty of those) which can include add-backs, inventory levels, loans to and from shareholders, client deposits, gift cards, etc.

Unfortunately, most prospective buyers lack the experience necessary to dissect the financials of a business, and that is why so many of them run into trouble and either buy a garbage business or grossly overpay for one. Just because a number is stated on internal statements or tax returns, does not mean it is accurate. I recently had a rare situation where the seller’s tax returns were terribly flawed and even though they depicted over $250,000 in Net Income, they were wrongly allocating loan repayments to themselves as expenses which, when properly allocated, actually increased their Profits. In this instance, the owner compiled their own tax returns (a foolish idea at any level). Usually however, the exact opposite holds true whereby numbers turn out to be far less than what was initially represented.

If a buyer is unwilling or uncomfortable with acquiring the necessary knowledge to be well-versed with financials then, at the very least, they must engage a highly experienced buyer’s consultant or accountant to assist with the business review and other steps in the business-buying process. The cost to hire talent is generally meaningless compared to the value they can contribute to the overall deal, the potential reduction they can negotiate on the price, and the guidance they provide to steering you towards the right business and away from the wrong business.

The lesson in all of this is that anyone who is serious about buying a business has to become equally serious about understanding financial statements. It is NOT a matter of simply handing over the books to your accountant. That will help of course, but it will get quite expensive to bring in an accountant for every business a buyer considers. Moreover, having a superb grasp on financials will prove to be a huge asset when a buyer becomes a business owner.


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