Thinking about buying an existing business instead of starting from scratch? It’s an exciting opportunity to leverage an established brand and start earning right away. But how can you be certain that the business you’re buying is a good one? One of the most critical aspects of your research is analyzing the financials. The financial reports will provide insights into the business’s viability, potential red flags, and inconsistencies. Let’s explore the three key financial reports you should examine before purchasing a business.
- Income Statement – Understanding Profitability: An income statement, also known as a Profit & Loss statement, reveals the financial performance of a business over a specific period, typically a year. It shows how much money the business has earned, the expenses incurred (raw materials, merchandise, operating costs), and the resulting net income or loss. A financially healthy business consistently generates a profit after covering expenses. Fluctuations in profit require deeper investigation, such as analyzing sales volume, pricing strategy, or overall viability. Be cautious of sellers who emphasize potential without explaining why it hasn’t been realized.
- Balance Sheet – Assessing Assets, Liabilities, and Equity: The balance sheet provides an overview of what the business owns, owes, and the resulting equity. It offers a snapshot of the business’s financial position on a specific date. Key components include:
- Assets: Cash, equipment, accounts receivable, and other valuable holdings. Assess the liquidity of assets (e.g., how quickly can inventory be converted into cash) and the business’s ability to sustain itself without accumulating more debt.
- Liabilities: Debts, loans, accounts payable, payroll taxes, and other financial obligations. Simply put, what a business owes! In an asset sale, the buyer typically doesn’t assume the seller’s debts as these are paid off by seller at time of sale.
- Equity: Represents the owner’s interest in the company’s assets after ‘removing’ its liabilities.
- Cash Flow Statement – Unveiling the Money Flow: The cash flow statement provides a detailed view of the money flowing into and out of the business. It comprises three sections:
- Operating activities: Revenue generation and associated expenses. Assess whether the business generates enough income to cover the fixed and variable costs.
- Investing activities: Cash that comes from selling assets and spent on buying assets (e.g., equipment, property).
- Financing activities: Involves obtaining funds (debt or equity) for business operations.
A healthy cash flow statement demonstrates that the business generates more money than it spends. It not only covers expenses but also allows for asset purchases and ability to grow.
Remember, understanding the financial story is crucial when buying a business, along with many other factors. By delving into the income statement, balance sheet, and cash flow statement, you gain valuable insights that will guide your purchasing decisions and set you up for success in your entrepreneurial journey.