This analysis is taken from the perspective a buyers due diligence on a small business acquisition. It is by no means exhaustive (simply as businesses span so many industries and occupations), but should aid covering reasonable material lines of enquiry. Most small business accounts are not formally audited, so any buyer must rely on the integrity of any accountancy firm that prepared the accounts (Who will invariably disclaim all liability for accuracy) and their own intuitive deductive rationale.
Note: Understanding financial statements is different from investigating their authenticity from a due diligence acquisition perspective. At the end of this analysis there will be a link to a further article should you wish to further investigate in more detail from a due diligence acquisition perspective.
Hence, here are the financial statements of a generic example small company business. We will go through each of the lines, line by line further below.
So, lets now work through the individual lines firstly in the Income Statement then the Balance Sheet. The Income Statement is the trading account and the Balance sheet is the Assets, Liabilities and the Owners equity.
Sales (A) - This is relatively straight forward. Any sales on credit or for cash should be observable flowing through into this figure. Supporting documentation to verify should be bank statements and sales tax/value added tax filings that should be reconcilable back to this total. The tax return filed should also be reconcilable back to the Income statement presented. In some businesses that have a project focus adjustments can be made at year end to apportion the implied 'profit' of the work undertaken, this is discussed more in, In Progress (C). Another note is that businesses that have high cash sales, the owner can be more likely to registered these in the accounts in the year(s) preceding the sale.
Fees (B) - This is similar to sales with respect to analysis, verification and apportionment. Professional service type businesses that sell expertise rather than products, use this income category.
In Progress (C) - This has been separated out for discussion, normally apportionments for 'earned' but not billed amounts are usually an year end accounting adjustment and included within the Sales or Fees. As a basic example imagine a bespoke furniture producing a large order that straddles a year end accounts date (As above 31 December XI), generally if 2/3rds of the order has been achieved then 2/3ds of the project is taken to the Income Statement.
In most cases you will want to see any accounting adjustments made to the accounts at the year end to fully reconcile the statements back to underlying documents such as Bank Statements, Sales/Value added Tax filings and Tax returns.
Interest / Miscellaneous (D) - Normally this should be a catchall and not material in nature. A bit of interest, maybe a small credit that is easier to just place there. If the figure is more material in nature then it should be investigated as to its nature.
Cost of Goods Sold (COGS) (E) - This is more relevant to businesses that sell or fabricate goods.
Consider the following example which shows the calculation by which the Cost of Goods Sold was arrived at.
The Opening Stock figure is the balance of the stock on hand from the preceding years closing financial statements. In effect on Day 1 of the current financial years accounts it was 26,000.You should be able to evidence this number in the Balance sheet of the prior years accounts. Then during the current financial year 161,000 worth of stock purchases were made. The stock initially on hand + purchases facilitated the Sales (A) of 234,000 and the In Progress (B) of 54,000. However at the end of the current financial year it was assessed that Closing Stock (Y) on hand was 42,000 so this is deducted to arrive at the stock that was used to facilitate the current year sales, being the 145,000 Cost of Goods Sold.
Stocks are valued at cost in a going concern business, subject to any write downs.
If you know last years closing Stock amount from the financial statements (Balance Sheet - Current Assets) and you know this years closing stock balance, and you know the Cost of Goods Sold from the current years Income Statement then you can deductively work out the implied purchases.
Looking at the Cost of Goods Sold as a function (%) of Sales Income (Products) you can understand the margin (Mark Up) being made on stock purchases or material fabrication processes.
End of year stock valuations in Small Businesses (That are closely held and not subject to external audit) can be somewhat subjective and dare I say estimated retrospectively. Hence, prudence needs to be applied, as Stock valuations can have material impacts on the Income Statement. As an example, envisage Stock on hand growing at a faster rate than Sales over a few years, Why? Maybe the warehouse is filling with unsellable stock that should have been written down, which would have lowered the profitability of the business. Maybe the stock was more 'guesstimated' (Especially if physical stock management is limited). There are other potential reasons, but if stock is material to the business then it requires a material focus and good controls.
Accounting / Legal (F) - Potentially also classified under professional fees. Any regular accounting preparation or legal fees. Some Accounting / Legal fees related to irregular activities can be rolled up into the purchase cost, such as Land / Buildings and some Leases.
Depreciation (G) - This is an amortization of the Assets of the Business (Refer Fixed Assets B1) in the Balance sheet example. It is generally considered as representative of the diminution of economic use value. Generally there should be a Fixed Asset registered to back this up and the net value of the assets shown in the Balance sheet. The Fixed Asset register will show the Gross purchase price of the various assets and the accumulated depreciation deducted to then give an aggregate net value shown in the balance sheet.
Rent (H) - Where any property is leased then payments will be shown here. It should be reasonably consistent. E.g. If Rent is paid monthly then there should be 12 months of payments in a financial year. Other Rent related expenses may be also charged to this expense code, such as service charges, sinking fund contributions and various government related property taxes/charges.
Salaries (I) - Employee remuneration and on costs are coded here. In Small Businesses you may see the Owner, their spouse and even children as paid employees, this can be tax efficient in some instances.
IT / Consumables (J) - Reasonably straight forward, Anything not considered an Asset that is IT (Information Technology) related can be expensed here. Printer Ink, Paper, Lease payments on Technology, recurring fees on software licences, IT consultancy charges to fix IT issues etc.
Interest (K) - Any bank overdraft or Loan interest. In this example it relates to the Loan liability shown in the Balance sheet (Loan F1).
Bank Fees (L) - Usually minimal but invariably separately shown as a line item.
Office expenses (M) - Generally a catchall for any expense item that doesn't fit elsewhere and is office related. Stationery etc.
Heat / Light / Power (N) - Effectively all the utility expenses for the office.
Shipping / Postage (O) - Depending on the type of business, this could easily become part of Cost of Goods Sold (E.g. Ecommerce sales and distribution), but in this example a smaller less material office based cost, sending out mailers etc.
Telecommunications (P) - Office networked phones, lease costs, Mobile phones and associated charges.
Subscriptions (Q) - Another general standard expense code. Often office magazines or professional subscription fees.
Maintenance (R) - Any cost elements relating to maintaining assets / leases often end up here. E.g. Painting the office, Fixing anything, replacement of small asset value items that are directly expensed.
Travel National (S) - Travel and accommodation domestically.
Travel International (T) - Travel and accommodation internationally. In Small Businesses this is often owner travel to international exhibitions.
Advertising (U) - Anything from online advertising through to direct mailers / sponsorship and so forth.
Entertainment (V) - Generally any client engagement by way of Lunches / Dinners / attendance etc., that doesn't meet the test of being advertising.
Net Profit (Before Tax) (W) - Operating Profits before tax. The Income of the business less expenses. Actual taxes on profits and dividends do not generally form the basis of a valuation calculation in Small Businesses. At the base of this article there will be a link to a worked small business valuation calculation.
Cash at Bank (X) - Closing balance of the bank account at year end. Should be evidenced by a relevant bank statement.
Stock (Y) - Physically evidenced stock on hand at balance date. Should be supported by a stock list. Any stock that is shop spoiled, damaged or has issues with saleability should be written down to net realisable value where this is lower than cost. Stock is normally valued at cost.
Debtors / Accounts Receivable (Z) - The amount of sales generated debts outstanding. Will be supported by an date aged reconciled schedule of customers. Debts with ages in excess of normal trade terms should be assessed for recoverability. Good Debtor management ensures that as much cash is available as possible, to support the working capital and operational expenses of the business.
Work in Progress (A1) - For businesses with income that is project related, and straddles the end of year cut off balance date, then unbilled elements can be treated as work in progress. A small construction company would be a classic for this type of situation with some projects lasting a few months. Once again, like with stock, it should be evidenced with supporting calculations/schedules.
Fixed Assets (B1) - Will be supported by a Fixed Asset (FA) schedule. The FA schedule will list all the assets at their initial purchase value (Gross Value) and have a life to date accumulated depreciation shown against it, with a residual Net Value shown. The sum of the Net Values is shown as the Fixed Asset balance, in the Balance sheet. The current year increment of depreciation is added to the previous years accumulated balance to come to the current years accumulated depreciation in the FA schedule. The current years depreciation is shown in the Income Statement, in this example refer Depreciation expense (G).
Note: The Fixed Assets schedule is generally not maintained very well, often the Asset schedule has numerous differences with the physical reality of assets within the businesses. Technically, the Fixed Asset schedule should be reviewed and matched with physical assets at the end of each financial year. Materiality is often insufficient when the business owner is more concerned with trying to get a physical stocktake undertaken etc.
Trade Creditors (C1) - These are normal trade suppliers balances due at Balance date.
Taxes Payable (D1) - In a company entity (LLC, LTD, PTY etc) the current years balance of tax payable may fall into a following financial year. Valued added Taxes, Sales Taxes also fall under this liability categorization. These too, will all have supporting schedules of previous filings to support these liabilities.
Other Creditors (E1) - These are any short term liabilities payable that do not fall into the other categories. As an example lets assume Rent is payable in arrears, so at balance date a months liability will exist for Rent, As with all other balance sheet items, relevant supporting documentary evidence should exist.
Loan (F1) - This is the balance outstanding at year end (Balance date). The interest element for the year is expensed in the Income Statement, in this example Interest (K). Lots of bank charges and interest payments in the Income Statement without any Balance Sheet Loan may be an early indicator that the business has cashflow issues, and relies on Bank Overdrafts.
Capital (G1) - This is the initial seed capital that Limited Liability Companies (LLC etc) are set up with. Generally (As an example) it is along the lines of 100 shares at 1.00 thus comprising Issued Capital of 100.00. Issued Capital rarely changes, will therefore be constant over numerous years, in the financial statements.
Retained Earnings (H1) - Current year Retained Earnings is comprised of last years Retained Earnings plus this years Profits (After Tax) less any dividends paid.
Note: The Retained Earnings plus the initial Capital, equate to Total Owners Equity.
Finally: If you would like to see a worked example of a Small Business valuation (on this website) then please click Here.