Getting Your Financial House in Order

having a clean report

Your sales presentation to a prospective buyer will include the company financials for the past 3 years. Therefore, you should always prep your business to show a 2 or more years upward-trend that supports your market value.

We will review the financial requirements needed to secure the maximum value for your business. Our topics:

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financial reporting prep

Analyze The Income Statement

Item 1: Are Your Sales Trending Up?

This is an expected requirement before any business will sell. If your sales are trending down, it's best to revisit your marketing strategy prior to listing your business to sell (unless your strategy is to exit the business at any price).

The buyer will analyze the sales numbers. They will want to know what strategy you have in place that will support these sales figures when you transfer the business over to them.

Additionally, the buyer will want to know:

  • how strong is your brand and goodwill
  • how strong is your product or service offering
  • how are your customer contracts supported and renewable
  • how dependent is the business on the owner:

    note: your business will be more valuable if it is NOT dependent on you.

If your business brand, product, customer contacts, etc., are dependent upon your management, you must prep your business to carve yourself out of the picture by:

  1. sharing your expertise and contacts with key employees
  2. bringing key employees to the front of the line to assume responsibility -- you begin to move to the back of the line
  3. assigning key relationships with employees so that the customer feels comfortable not having you in the picture.

Item 1: Are Your Indirect Expenses Trending Down?

The second line item the buyer will scrutinize is your expense items. They want to see expenses that are strategically managed — in other words, expenses incurred must support the operating business and marketing strategy.

Frivolous expenses only raise questions about your financial assumptions.

Prep your business by removing:

  • expenses that are non-business related:

    you accomplish this by paying off company loans made for personal or non-business use

  • expenses that do not produce income:

    analyze individual line items and pay-off or terminate service relationships for expenses that do not generate income.

Prep your business by documenting:

  • equipment purchases that support the business operations and sales strategy
  • expenses items that are part of your marketing strategy

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financial reporting prep

Review the Company Assets

Current Assets

Selling the company means selling the company assets. The buyer is only going to pay for income-producing assets.

Current assets include the following:

  • accounts receivables
  • inventory
  • short-term notes
  • other

The buyer wants to see collectible receivables dated no longer than 30 days or within industry standards. Invoices or receivables dated more than 30 days indicate sloppy management and/or troubled collections.

  • You should review your collection policy to ensure that bills and payments are invoiced and collected on time.

The buyer will evaluate your inventory management. Dated inventory may be worthless in the eyes of the buyer, regardless of book value. If you can't sell the inventory, the buyer doesn't want it.

  • Get rid of your excess inventory by writing in off or donating it at book value. Keep your inventory at marketable levels.

Short-term notes generally include loans made by the company to the owner or owner's family.

  • You should pay off these loans prior to the sale (or state that they are excluded from the sale). The buyer will not assume any short-term notes not directly tied to the operation of the business.

 

Fixed Assets

What are the fixed assets:

— leasehold improvements
— furniture and fixtures
— equipment (machinery and tools)
— company vehicles
— building(s)
— land
— other

Fixed assets that should be included in the sale are those assets that are income-producing:

  • Company vehicles used exclusively by the owner or owner's family should not be included and removed.

  • Land and building valuation must be supported by an independent appraisal if it is included in the sale.

    Note that many buyers will not purchase land and buildings — they don't produce income. Sellers often remove land and buildings from the sale and lease them back to the business.

  • Leasehold improvements that produce income or directly tied to the business operations should be included — other lease improvements that do not produce income should be removed.

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financial reporting prep

Reviewing the Company Liabilities

Selling a company comes with its obligations. The obligations that should be included are those line items that produce income.

Current liabilities include the following:

  • accounts payables
  • salaries
  • short-term notes
  • other

The buyer wants to see payable accounts thatsupport the day-to-day operations of thecompany. These accounts should be paid on-time, taking advantage of discounts and other payable perks.

  • Accounts payables that are not operating expenses should be removed or paid off prior to presenting the company to the prospective buyer.

Short-term notes include loans that must be paid back within 5-7 years. These loans should be exclusively tied to the operating needs of the company.

  • If at all possible, you should pay off these loans prior to the sale. Many buyers do not want to assume any short-term loans.

 

Long-Term Liabilities

What are the long-term liabilities:

— long-term notes for building and land
— long-term notes for equipment
— other long-term notes
— other

In most cases, buyers will only assume those obligations that are directly tied to the income-producing assets of the company, such as operating equipment.

Buyers generally will not buy the land and building if it is owned by the seller. Including the real estate in the sale will increase the cost to the buyer while keeping the company earnings at the same level. The buyer's going cash position will be decreased making the business less attractive.

  • The seller's best option is to not include the building and land in the business sale. You should list the building and land as a separate sale if the buyer is interested. In many cases, the business owner leases the facilities back to the buyer with an option to buy.

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financial reporting prep

Recasting The Company Financials

Why Recast the Financials

Documented business financials are "minimized" to show as little taxable income as possible. The company's true economic value is generally greater than the reported taxable value.

To derive the economic value of a company, you need to recast the financials to show the company's true economic value.

  • For example, your tax position may allow you to take accelerated depreciation on capital investments.
  • Let's say you invested $10,000 in capital equipment. If you depreciated your investment within 3 years, the reported book value after 3 years would be $0. Does that mean that the "market value" for the piece of equipment is valued at $0?
  • That is why you need to recast the financials to show the true market value of the capital investment.

How to Determine Market Value

Market value reflects the cost to replace a piece of a equipment or asset to its current state minus its wear

  • It is advisable to re-value your assets and equipment on the low side. If the buyer questions the value you assign certain equipment, it may raise flags that question your intent and asking price.


Another related line item is the owner's salary and perks. You need to add back owner salary and perks to reflect the true financial cash position of the company.

  • For example, if the owner takes $100K in salary and perks showing a taxable income of $100K, you will need to add back the owner's salary and perks to show the true cash position of the company.


Recasting the financials reflects the true economic value of the business, prior to depreciation, non-operating interest charges, owner salary and perks, and non-recurring expenses.

Recasting the financials require:

  • adding back depreciation and reflecting the replacement value of capital equipment and assets
  • adding back non-operating interest expense taken for non-business use.
  • adding back owner salary and perks
  • adding back owner family salary and perks if it is unlikely that family members will stay with the company once it is sold
  • remove any bad debts that will not be forwarded to the new owner
  • remove any obsolete inventory
  • remove any assets that will not or should not be sold to the new owner; i.e., the company car used by the owner or members of the owner's family
  • write-off any loans the company made to the owner
  • other: to be reviewed

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financial reporting prep

Calculate The Cash Flow Position

The cash flow position must support the asking price. Think about it.

If you were going to invest $100K as a down payment to buy a company, the return of your investment needs to equal a cash return that is greater than the return if you invested the down payment in the equity markets.

Additionally, if you were going to expense your "sweat equity" to manage and grow the business, the cash return must be greater in value than finding a job that would give you equal value.

That is why cash is a determinant factor when making a business purchase.

Measuring Cash:

Take the:

company's discretionary cash flow
use a 3-year or 5-year weighted average: see calculations

 

Reduce this by:

Annual debt service
this will include the principal and interest payments for financing the purchase price of the business less the down payment

Owner or manager annual salary
the market rate for managing the business either as the owner or through a hired manager

Capital Expenditures
the amount that must be paid to maintain, service, and replace business equipment and other fixed assets. A good benchmark is to replace all operating assets within five years. Take the market value of the operating assets and divide by 5

Return on Down Payment
the investment return on the down payment

 

Equals:

Remaining Cash Flow
this amount needs to be positive to justify the asking price.

 

Example:

Estimated Sale Price: $450,000
Buyer Down Payment @ 33%: $150,000
Business Financing @ 67%: $300,000
10.0%
7-Yr Note
Market Value of Operating Assets: $50,000
Estimated Return on Down Payment: 5.0%
 
Annual Sustainable Cash Flow: $175,000
Less: Debt Service $59,764
Less: Debt Service Cushion @20% $11,953
Less: Annual Capital Expenditures $5,000
Less: Return on Down Payment $7,500
Less: Owner's Salary $80,000
Cash Flow Coverage: $10,783

The example shows that my "down-payment" and "sweat equity" will generate a positive cash position after paying financing costs and deducting a cash salary.

*Note: Standard cushion required by lenders when underwriting this loan. This amount covers the cost of financing in the event of economic or market turndown. The amount is not an expense and would be an additional amount to cash flow.

Building Up Your Cash Flow

Increasing cash flow requires an

  1. the increase of sales and/or
  2. a decrease of expenses

Maintaining a steady flow of sales requires a supporting marketing strategy.

View our business topics on market planning and growth

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financial reporting prep

Making Financial Projections

what will the company look like in 3 years

The buyer needs to understand the expected projections over the next 3 years.

You generally achieve this by showing the growth projection made over the last three years and continue that trend going forward.

A more supporting projection can be made from a well-planned marketing strategy as discussed under our market expansion plays.

  • Targeting new segments, introducing a new product line, and launching an aggressive promotional campaign allows you to make assessments that support the increased value of your company.

It is up to the buyer to calculate the effects of competition, economic conditions, the prevailing market, and what the buyer can accomplish.

The 3-year forecast should reflect income before depreciation, non-business expenses and owner salary and perks.

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Helpful Tools

Some helpful forms business owners:

exit planning module
selling your business summary sheet
valuation calculators