How to Work With Small Company Financial Statements in Business Valuation
Have you ever asked yourself: how will I ever clean up this financial statement mess for a business valuation? You are not alone. Many small companies have notoriously improper financial records and error filled financial statements. This is often caused by a lack of understanding of what is required to have proper financial records. It is also caused by the drive to keep overhead as low as possible, which is an admirable goal that sometimes goes too far. If the company is profitable, the owner and management may get away with sloppy records until they need to apply for a bank loan, add a partner, or perhaps sell the business; or they need a business valuation for another reason.
One of the primary differences between valuing micro and small businesses and larger businesses is the quality of financial statements. Larger businesses tend to have reviewed financial statements at the very least, while many have audited statements. These businesses have true accounting and financial departments and people with the skills to keep proper GAAP records– or at least to understand and report the variances.
One of the nice things about running a small business is you get to run it your way. But, when third parties need to review your financial statements, you need to do it their way, at least to a certain degree. Here are some ways to get these financial records in shape for someone else to use them.
Know the limits of cash basis accounting.
Cash basis accounting is one of the most common things we see with small businesses. This is an accepted method of accounting, but it might not give useful financial information for many purposes. Cash basis is particularly prevalent on tax returns used to value small businesses since the cash basis better aligns tax liability with the receipt of money to pay the taxes.
For example, if the company being evaluated has large accounts receivables but the timing of collection varies, it can be difficult to get a complete picture of the true underlying cash flows. This is because accounting periods have end dates, but ongoing businesses do not have end dates. Each of these accounting period end dates represents a cut-off, but we don’t know what happens the next day. An income statement that ends on December 31 will not show a huge receivable collected on January 5, and therefore is not a complete picture.
Be aware of outright accounting errors.
Outright errors on company financial statements present another issue for business valuation of a small company. The valuator or other reviewer must always be on the outlook for material errors. Usually these errors are accidental, but may not always be. Errors often even show through on tax returns prepared by third party tax preparers. Some common errors are:
- Overstating the cost of goods sold and understating inventory. This practice reduces profit and therefore taxes. Often companies only overstate a small amount of goods sold each year, but over time this can become a big problem. Take a small retailer with $300,000 of inventory and $90,000 of profit each year for example. If they overstate the cost of goods sold by $30,000 for 10 years on their tax return, by the tenth year, they will not have any inventory for tax purposes. However, they would still have $300,000 of inventory on the floor and in the back room. They will have also understated profits by $30,000 per year, or 25% per year–a significant percentage. Over the 10 years, they will reduce profits by $300,000. This can create both valuation and tax problems if discovered.
- Failure to show inventory at all. This just creates a complete mess for inventory rich small businesses. In many cases, it leaves the company unable to be valued, obtain a loan, or be sold.
- Failure to write off un-collectable accounts receivable under the accrual method. Some businesses never write off uncollectable accounts receivable. This causes income to be overstated. This is usually fairly easy to adjust if underlying data about accounts receivable is properly tracked.
- Expenses being recorded under a variety of names. We have seen office rent shown as rent expense, mortgage payments, and lease expense all in the same year for the same company. Those types of errors make it hard to review the data for consistency and figure out what the real amount is if an account needs adjustments.
These are just a small sample of accounting errors that impact financial statements and tax returns used in business valuation of small businesses. As the old computer programming adage goes, “Garbage in – garbage out.” In most cases, with care we can clean these mistakes up and feel comfortable that the financial statements reasonably represent the company that is the subject of the business valuation. But in some cases, we may have pure garbage that may make giving an opinion of value in a business valuation impossible.
I’m a JD, CPA and Certified Valuation Analyst, and I know that business valuation is both an art and science. To find out more about professional valuation services for your business, contact me to learn more.