Buying a Business: How to Read Financial Statements

By on April 10, 2014

It can be pretty easy to figure out how good your own company is doing financially. Is there money in the bank and is it still coming in? Then you are on the right track. What can be a little more confusing is determining if a company that you want to invest in is in a good financial position.

5 Tips for Seeing the Big Picture of a Company thru Financial Statements

1. Ask For 3 Years Of Reports

You will need Profit and Loss Statements (also called Income Statements), Balance Sheets, and Cash Flow Statements. You want a minimum of three years of reports for your research. If the company is tracking and reporting properly, you should get an extra year from the comparison to previous year sections of the reports. Three years will give you an accurate picture of how the company has been doing recently. If the current owner is shady about providing them or they are missing data, you might be making a bad investment.

Also, if the business is owned by a single person or family, request the personal income tax statements from the owner. With those, you can tell if the owner has been supporting the business with their personal money, which is a sign of a failing business. Use the tax returns to compare against the increase or decrease in Owner’s Equity section of the Balance Sheet. If a person claims on their personal taxes that they spent a lot on the company, but the Owner’s Equity does not change, then they may be hiding things.

2. Look at the Bottom Line First on P&Ls

Your first question should always be ‘Does this company actually make money?’ You are going to be buying a company and you will need a return on that investment. Check the line for Net Profit on the Profit and Loss Statement. From there, go back and start at the top to determine the amount of money coming in and going out. If a company was unprofitable three years ago, but the last two years have been good, then you might be alright.

As you go through, look at changes between the current year and previous years. If you are going to be buying a business and not just investing in it, it can be worth it to enter all the data into your own spreadsheet to see how it changes over the years. Things that you should ask questions about are any numbers that seem large in comparison to other years. Speak to a business consultant who can tell you if certain numbers are higher or lower than they realistically should be. Some examples could be:

  • Cost of vegetables for a restaurant is low because the current owner was buying directly from a farmer instead of through a restaurant supply company.
  • Cost of cigarettes at a convenience store is high because of a loss of buydown discounts due to violations of contracts.

3. Check the Salaries and Wages Data

Every company has employees, and you need to see how much they are paid. Check to ensure that the company is paying their employees correctly and legally. If a company is paying out employees under the table or out of the register at night, you should walk away. There are too many issues that you can have if the employees report the business, even if it did not happen while you were the owner.

The other thing to look for is to see if the current owner was paying themselves appropriately. This is another place where having the current owner’s personal income tax forms will benefit you, because you can check what they reported earning personally versus what the reports state that the business paid them.

The biggest thing that you want to take away from this is to figure out if you can maintain your current standard of living with what the business was bringing in for them. If they only reported making $2000 per month, can you live on that? If not, then that business will probably not be a good investment.

4. Check the Cash Flow Statement for Solvency

Use the Cash Flow Statement to determine how much cash is available for necessary uses, like purchasing inventory, paying current bills, and most importantly, paying your employees. The business can have a lot of assets like inventory and property, but that does you no good if the company can’t keep the lights turned on.

Since the Cash Flow Statement can be confusing to some people, you should seek a professional consultant or accountant to run some of the formulas they know to check on the solvency of a company.

5. Check the Balance Sheet to Ensure that the Overall Picture is Improving

The Balance Sheet can be a very telling piece of paper to determine the End-of-Year snapshot of the company. While it can be confusing for larger companies, a small business balance sheet can be pretty simple.

Focus on the Assets first. Is there appropriate growth across the board, or does the company own a lot of stuff without the means to pay for it? Then check the Liabilities section. Comparing the P&L to the Balance Sheet, does the company have the income ability to pay off its debts? If liabilities are increasing, such as taking out a bank loan to keep the company afloat during a rough period, will the company make enough money later to pay back the money?

Lastly, check the Owner’s Equity section. If the current owner is keeping the business afloat through a short rough patch, that is fine, but a consistent pattern can be a major sign of a failing business. If the amount of Owner’s Equity is decreasing, then the business is showing signs of profitability, but make sure that that lines up with the owner’s personal income statements.

Get Some Expert Guidance from a Professional

These tips are a great starting point, but most of the time you will need more information or insight into why things are increasing or decreasing as they are. At that point, you should seek out a business consultant or financial advisor who can look at these records and determine the ‘Why’ behind the numbers.
The specialized knowledge and abilities of a professionals will be the best safety net you have when you are planning to spend a large amount of money. When you are about to invest a large amount of time and money into a new business venture, the more information you have, the better your decisions can be successful for the long-term.

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About Charles Wazig

FSN Business Columnist - Charles Wazig has been a business consultant for the past 10 years and has aided small and medium sized enterprises start and grow in almost every industry. Understanding markets and financial forecasting can be a daunting task, and Charles strives to make it easier for the common person to be fully prepared for creating and running their business. You can find Charles on !

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