Buying and Selling a Small Business - Chapter 4 - Sources of Financial Information

The buyer can usually find financial information in the following places: (1) financial statements, (2) income-tax returns, (3) other internal records, and (4) other external sources.

Financial Statements

Balance sheet and income statement. The balance sheet is a statement of the financial position of the business at a given moment in time. The income statement is a summary of the revenue and expenses of the business during a specified period of time. These financial statements show only the past results of the company's transactions. The results of future operations may or may not be similar.

Balance sheets and income statements in themselves contain important information, but they are most useful when a professional accountant makes a detailed analysis of them. A complete analysis includes a review of the manner in which the statements were prepared, and perhaps also a review of the records and control features of the accounting system. This is especially important in a small business buy-sell transaction because the financial statements of smaller companies are not usually as professionally prepared as the statements for larger companies. An accountant should be brought into the buy-sell transaction as early as possible by the seller as well as by the buyer.

Audited statements. In many buy-sell transactions, the statements are supplied by the seller, but the buyer reserves the right to conduct an audit of the seller's records. Or the buyer insists that the seller "warrant" his financial statements. Warranty of financial statements by the seller should be accepted with caution, however, because there does not seem to be any uniform definition of the term warranty.

If the seller's financial statements are prepared by an independent accountant, the statements should show whether they were (1) prepared after an audit of the seller's accounts, or (2) prepared from the seller's records without verification by audit. If they were prepared without verification by audit, they may be quite similar or even identical to statements that would have been prepared by the seller's own bookkeeper. If they were prepared after an audit, they should include a statement of the accountant's opinion.

Financial statements prepared without such an audit may or may not reflect the financial position or results of operation of the company. Most small companies do not have their records audited annually, but without an audit it is impossible to tell how accurate the statements really are.

Other considerations. The buyer should request balance sheets and income statements for at least 3 and preferably 10 years. If the seller is a new company, financial statements for the entire life of the company should be requested.

Other financial statements are sometimes available to the buyer. These include such items as statements of cost of goods manufactured (if the seller is a manufacturer), application of funds, and variances from the budget.

Another point the buyer should consider is the cutoff period for the financial statements. The statements may have been cut off during the low period of the sales cycle or during the high period. This has some bearing on the financial position reflected in the statements.

More detailed information on financial statements and their analysis is given in chapters 9, 10, and 11.

Income-Tax Returns

Financial statements prepared for income-tax purposes may be very different from statements prepared in conformity with generally accepted accounting principles. Those prepared for tax returns are designed to present the desired tax position in compliance with the income-tax laws. Financial statements for nontax purposes have different objectives and therefore may reflect different financial information.

Many small companies prepare financial statements only for income-tax purposes and use those statements for all management decisions. This may or may not give the desired results. The parties to a buy-sell transaction are interested in statements reflecting the tax position, but they should concern themselves also with statements reflecting nontax items.

The buyer should request copies of tax returns for at least 3 and preferably 10 years or, if the seller is a new company, for the life of the company. The tax returns are more important in buying the stock of a corporation than in buying the assets of a corporation, partnership, or sole proprietorship.

The corporation is an income-tax entity; the partnership and sole proprietorship are not. A partnership is required to file income-tax information returns but does not pay income taxes as a company--the taxable income is passed on to the partners, and they pay the tax as individuals. No tax return is filed for a sole proprietorship, but the income statement is included as a part of the sole proprietor's personal income-tax return.

The buyer should find out which tax returns have been examined by the Internal Revenue Service and which have not. This is particularly important if the buyer is purchasing the stock of a corporation. If a corporation with an operating loss is being acquired, the loss might have value and the buyer should satisfy himself as to whether this net operating loss can be utilized. In many instances, the only information available to the buyer is that found with the income-tax returns.

Other Internal Sources

Sales may have been analyzed by customer, product, division, salesman, time period, and any other classifications necessary.

Purchases may be classified according to product, time period, territory, supplier, or other classification. If the seller is a manufacturer, he may have cost-control reports that include analyses of material costs, labor costs, overhead cost, scrap sales, spoiled and defective goods, and other items.

There may be a cash-flow statement--perhaps incorporated with the analysis of collections of accounts receivable--and even a projection of cash requirements.

The seller may have a regular budgeting program with projections into the near or distant future. It is common practice for the buyer to require the seller to make a projection for at least a year from the date of the proposed transfer. The buyer should insist on this projection.

Other External Sources

Another source of data is the seller's banker. A banker can supply information about cash position, line of credit, and other fiscal data. He may, however, be reluctant to release this information.

The seller may have filed payroll-tax reports, sales-tax reports, excise-tax reports, ICC reports, or any of many other government reports. Some of this information is available to a buyer.

The buyer may seek information about the seller from credit agencies or credit associations related to trade associations. Usually, the buyer must have a contact with these agencies in order to get the information, but there are many ways to get reports about the seller.

A number of organizations, including trade associations, supply information about industry averages. These averages are very important to the buyer for judging the effectiveness of the seller.

Advice to the Seller