Buying an established company can be a great strategy for an aspiring small business owner to own their own business without starting from scratch. However, evaluating the sustainability and financial health of an existing business is crucial before signing the contract.
“The difference between successful and failed transactions often comes down to rigorous financial due diligence and meticulous preparation,” said Sidharth Ramsinghaney, Director of Corporate Strategy and Operations at Twilio. “Systematic pre-deal analysis and post-deal integration planning are the key determinants of deal success.”
Here’s some key financial information to request when considering a business acquisition and how to properly evaluate it.
Documents to request when buying a business
Before you sign any sale contracts, be sure the seller provides these seven documents for your review.
Profit and loss statement
To understand how profitable the business is, review its revenue, expenses, net earnings, costs of operation, and the owner’s salary in a profit and loss (P&L) statement. Typically, when purchasing a business, you should request a current version of a P&L statement (no older than 180 days) to ensure you’re reviewing the most recent financial history, as well as several years’ worth of P&L statements to better understand the company’s financial trends year over year.
Some important elements of a P&L statement include:
- Revenue/income, or how much the business receives for its goods and services.
- Cost of goods/services, or how much it costs to produce a good or service.
- Gross profit, or the business’s total revenue minus its cost of goods and services.
- Expenses, or the cost to operate the business, including payments like salaries, leases, and office supplies.
- Net profit, or gross profit minus the business’s expenses.
One important consideration when looking at a company’s profit margins is how they compare to industry benchmarks, said Crystal Stranger, CEO of OpticTax.com.
“I had a client bring a deal for me to review … in the home health care space and I thought the 10% margin seemed quite low. Then I learned that 10 to 15% is standard in that industry,” she explained.
[Read more: Creating a Financial Accounting Report With the Four Basic Statements]
Balance sheets
A balance sheet provides a breakdown of the business’s assets, such as cash, equipment, inventory, and property, alongside the company’s liabilities, like debts or employee wages. You can total those numbers and subtract the total liabilities from the total assets to determine the owner’s equity in the business, or the capital remaining for the business owner(s). This simple calculation can help you determine a reasonable selling price for the business as well as if the purchase is worth pursuing.
Stranger warned prospective buyers to watch for balance sheet discrepancies from year to year.
Bank statements
While P&L statements and balance sheets show a good summary of financial performance, raw transaction records and bank statements can help you verify those numbers and expose any discrepancies between reported revenue and actual deposits.
“The most revealing red flags often appear in month-over-month operational metrics rather than annual statements,” Ramsinghaney told CO—. “Subtle variations in working capital patterns [can expose] underlying business model weaknesses.”
Tax returns
Request the past three to five years of tax returns from the seller, which should include the business’s date of formation and the compensation of its officers, as well as any assets and liabilities.
Depending on the tax form, you can discern different information about the business—even beyond its revenue or debt-to-income ratio. For instance, consider how much the business pays in employment tax (required for companies with W-2 employees), as well as associated self-employment taxes, which come with running your own business. Additionally, consider how much you will likely have to pay in estimated taxes per quarter.
If you uncover any financial concerns during your due diligence process but still want to move forward with the purchase, you’ll want to negotiate terms to protect yourself before finalizing the deal.
Cash flow statement
A cash flow statement demonstrates how cash moves in and out of the company. This document gives you a sense of the day-to-day operations as well as a rough estimate of how the business can continue operating once you purchase it. Plus, you can see if there are any expenses you can cut by managing the company differently, potentially boosting your earnings once the sale has closed.
John Silvestri, General Counsel at Craveworthy Brands, advised first reviewing the business’s operating cash flow, which will tell you how much cash the business generates from its core operations. Then, evaluate free cash flow by subtracting capital expenditures from operating cash flow.
“[Free cash flow] provides insights into the company’s ability to fund future growth or distribute profits to shareholders without relying on external financing,” Silvestri said.
[Read more: How to Create a Financial Forecast for a Startup Business Plan]
Debt and liquidity
Silvestri noted that excessive debt can strain a company’s resources and limit growth.
“The debt-to-equity ratio helps evaluate financial leverage by comparing total debt to shareholders' equity,” he said. “The interest coverage ratio measures how easily the company can cover interest expenses with its earnings.”
You should also look at liquidity metrics like working capital, which can help gauge the company's capacity to meet short-term needs and immediate liabilities like debt payment, added Silvestri.
Accounts receivable and accounts payable
Accounts payable are expenses the company needs to cover financially, such as monthly expenses to suppliers. Accounts payable is considered a business liability. Accounts receivable is money the company is owed from customers, such as invoices for products or services delivered. Accounts payable is considered a business asset.
Although some of the information may be present in other documents, requesting these items separately allows you to cross-reference and pin down any discrepancies.
“If accounts payable remain outstanding for extended periods, it might signal underlying cash flow issues,” said Silvestri.
[Read more: Accounts Payable vs. Accounts Receivable: What's the Difference?]
Additional ways to evaluate a business’s financial health before purchase
Beyond reviewing financial documents, you should also assess broader operational factors that impact a business’s long-term financial stability and risks, including the following:
- Customer concentration. If too much revenue comes from a few key clients, losing just one could severely affect profitability, said Ramsinghaney.
- Leases and contracts. Silvestri noted that some leases may have personal guarantees that complicate transactions, while key vendor contracts might require third-party consent to transfer. Employment contracts should also be reviewed, as key personnel turnover after the sale could create challenges for you as the new owner.
- Technology infrastructure. According to Sylvestre Dupont, Co-founder of Parseur, “data may be the most valuable asset you’re acquiring,” so the company should have a streamlined way of processing and storing it. “If the company in question has many disparate data sources and lacks a centralized system to process and store data properly, it will cost you time and money to develop effective infrastructure,” Dupont said.
- Pending litigation. Silvestri advised reviewing ongoing lawsuits and any threatened litigation, which could expand a company’s financial risk. Buyers can uncover hidden risks and make more informed investment decisions by assessing these operational and structural factors alongside financial reports.
What to do if you spot financial ‘red flags’
If you uncover any financial concerns during your due diligence process but still want to move forward with the purchase, you’ll want to negotiate terms to protect yourself before finalizing the deal. For instance, Silvestri said a buyer might consider asking for different pricing terms (e.g., a lower sale price or contingent pricing terms based on pending tax audits or litigation), establishing an escrow fund to cover outstanding liabilities, or building in warranties and indemnification clauses against specific financial risks or issues.
“Another area of protection is a Material Adverse Change clause, which allows you to renegotiate certain points or terminate altogether if a major business event occurs,” Silvestri added.
By taking these precautions, buyers can mitigate risks and ensure they make a well-informed investment decision.
Rachel Barton contributed to this article.
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