Focus on Financial Statement Quality Well Before a Sale Process
Business sales are complex and involve the analysis of numerous factors such as historical sales, a company’s level of profitability, and expected industry or company growth. The source for much of this information is a company’s internally produced financial statements. Although every company generates financial statements in some shape or form, the quality of the statements varies widely and typically comes into focus when an owner begins the sale process.
But quality financial statements are not just important for the sale process, they are critical to the successful operation of a business. It is advisable to consider how financial statements are produced well in advance of beginning a sale process. In this article, we will cover the importance of clean accounting records, the benefits of regular review policies, the interdependence between financials and valuation, considerations for increasing value, and the relationship between good record keeping and operational efficiency.
The Importance of Clean Accounting Records
Clean accounting records are beneficial as a foundation for informed decision making, but small businesses often put accounting infrastructure to the side in favor of other functions, especially customer facing functions. When relying on accounting records for decision making, or when turning over accounting records to an external party, statements should be as transparent and accurate as possible.
The risks of poor recordkeeping are many, ranging from inaccurate conclusions about a business, to a buyer walking away from a deal because they lack bandwidth required to restate the records and to make sense of the statements.
For example, a prospective buyer analyzing your income statement might not know the nicknames for accounts. Although it might make perfect sense to you and your team, unclear account names can leave buyers confused and hesitant about moving forward.
Additionally, leaving large amounts in “Other Income,” “Other Expenses,” “Reconciliation Discrepancies,” and “Ask My Accountant” can lead to even more confusion for your buyers. Working with an experienced bookkeeper will ensure your general ledger has clear account names, contains accurate balances, and follows proper cut-off procedures.
The Benefits of Regular Financial Statement Review
Regular financial review can lead to various benefits, from access to real-time data, to error detection, to improved internal controls and lower tax liabilities. Consistent financial review procedures create the ability to maximize the attractiveness of your business during ongoing operations, which translates to increased attractiveness during the sale process. By allocating a few hours each month to working with your accountant or bookkeeper to review the past month’s performance, you might uncover ways to increase profitability, speed up receivable collections, or grow sales, to name a few examples.
Understanding your business’s inefficiencies creates the opportunity to make changes and bolster your financial position. As businesses scale, this is especially impactful given the high dollar values at stake. For instance, a company generating $10 million of revenue and that uncovers 3% of expense savings may increase the business’s valuation by nearly $1 million. Take the time to regularly review your financials well before you expect a sale to occur.
Financials and the Impact On Valuation
It should come as no surprise that your financial statements impact your business’s valuation. The balance sheet highlights your business’s overall financial health, while the income statement shows profitability. Another statement that is commonly neglected is the statement of cash flows.
Overstating your cash flow levels can lead to unrealistic price expectations. Buyers will most likely complete extensive due diligence on the validity of your financial statements. Uncovering inaccuracies can not only lead to broken trust, but can also affect your sale price.
Miscalculations in any of the financial statements can impact a valuation. For instance, if you don’t have the proper revenue cut-off for the reporting period you may end up adjusting sales lower. Or if you miss the opportunity to capitalize assets on the balance sheet your profit may not be properly stated. Small discrepancies can make a business appear to be less profitable and stable, resulting in a lower valuation.
Is Growth Translating to Value?
There is value in growth. Prospective buyers will take notice of year-over-year growth rates. But they will also take notice as to how that growth translates to profit. Although there is value in growth, if that growth is reducing profit margins then it’s important to weigh the benefits of the growth versus the cost of the growth. Infusing accuracy into your financial statements ensures that you have data to back your claims of profitable growth.
One area that can be tricky for high growth companies to manage is the proper matching of revenue and expenses. If accrual standards are not properly followed, the story that financials tell may shape an unnecessarily poor narrative about margins. Forgetting to record a receivable at year-end or neglecting to adjust the cost of goods sold for inventory counts may result in a costly adjustment to valuation. Furthermore, these inaccuracies can lead to incorrect tax returns, or inaccurate reporting to third parties such as lenders. Noncompliance with lender debt covenants can lead to loans and notes due on demand. It goes without saying that tripping covenants rarely enhances the perceived value of a business.
Producing accurate financial statements positions your firm for success and is very important for showcasing its true value.
The Relationship Between Good Recordkeeping and Operating Efficiency
In our experience, there is a positive correlation between good recordkeeping policies and operating efficiency. When companies base decisions on up-to-date and accurate financial statements, they are often more successful at setting and adhering to strategic operating goals.
Maybe a company finds that raw material costs have increased by 5% but without notice from vendors, resulting in the realization that the company was over-billed. Or perhaps by understanding customer acquisition cost a business may project that sales can double with the addition of two sales personnel. Uncovering these insights relies on having accurate financial statements to analyze and also depends on owners staying close to the business’s performance data.
Improving your bottom-line profit and boosting efficiency will add incremental value to your ongoing operations. At minimum, business owners should complete monthly reconciliations, discuss progress with members of management, and define short-term and long-term goals. Working with an accountant or bookkeeper can be a great way to ensure that the accounting infrastructure is sound, statements are accurate, and that measurable goals are used to position the business for profitable growth.
Taking Small Steps on the Way to Better Financials
How confident are you in the accuracy of your financial statements? Whether you are six months behind on bookkeeping or neglecting regular consultations with an accountant, it’s important that you prioritize a shift in your mindset and actions. Business owners are busy and there is no shortage of demand for bandwidth. But financials are a key output for every business and are worth prioritizing.
With strong financials, businesses are well prepared to make better operating decisions, which leads to healthy operations and a business that’s positioned favorably for a sale process. Start with regular reviews of your financials with an accountant or bookkeeper, and continue familiarizing yourself with the inner workings of the income statement, balance sheet and cash flow statement. When it comes time to exit, you’ll be glad you prioritized financial statement preparation.
For more information regarding preparation of a business for the sale process, check out our complimentary guide here.
