When purchasing a small business, especially one with appealing earnings, it’s crucial to examine more than just the income statement. This lesson came to light during a recent consulting session with new Chinese entrepreneurs seeking to buy a retail store.
The Initial Red Flag
The prospective buyers were excited about the store's earnings, but my request for a complete set of financial statements—beyond the provided income statements—raised concerns. The current owner, who had been in place for a year and a half, hesitated to provide his own balance sheets. This lack of transparency set off alarm bells.
The Management Fee Mystery
Among the expenses, the income statement listed a management fee of $21,000. The owner claimed this fee, along with a salary, reduced the business’s taxable profit to zero—a common and legal tax strategy. However, the balance sheet revealed the fee had never been paid out; it was still owed, indicating the company lacked the cash due to principal debt payments.
The Critical Role of Balance Sheets
This scenario underscores the importance of reviewing the balance sheet, which provides a snapshot of the business’s financial health on a specific date. Unlike the income statement, the balance sheet can expose hidden liabilities, such as unpaid management fees or debt obligations, which can severely impact cash flow.
Manipulating Financial Statements
Owners can also manipulate inventory counts to adjust the cost of goods sold (COGS) and affect reported profits. By inflating or deflating inventory levels, they can paint a misleading financial picture. This tactic, known as "painting the tape," can make a business appear more profitable than it is.
Conclusion
When evaluating a business, always request comprehensive financial statements, including balance sheets and cash flow statements. These documents provide a complete and accurate story of the business’s financial state, helping you avoid hidden "balance sheet landmines" that could jeopardize your investment.
By being diligent and thorough in your financial review, you can make a more informed decision and safeguard your investment against unforeseen financial pitfalls.
Click here to download a balance sheet checklist we’ve prepared for you this week.
Cheers
David C Barnett- don’t forget to subscribe to the email list if you haven’t already https://www.DavidCBarnettList.com
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