It’s always an interesting question whether to evaluate a business on a cash vs. accrual basis. Maybe not always an interesting question, considering the majority of the world doesn’t care. But for people in the ETA world, it should be exciting. My job is to uncover the whole story when I look at a business about to be acquired. I can’t promise that I’ll be able to find the $250,000 hiding in the banana stand. But I can promise that I’ll be able to point out the $250,000 hole it leaves behind. Comparing records on both a cash and accrual basis lets me do more than just find these random gaps. It lets me evaluate how healthy a business actually is. Quick 101 on Cash vs. Accrual I’m proud to say that my mom reads these newsletters. For her sake (and probably a lot of other readers), I’m going to give a quick breakdown on the difference between cash and accrual accounting. Cash basis accounting records income and expenses when the money actually hits the bank or leaves it. On the other hand, accrual basis accounting will record income when it’s earned and expenses when they’re incurred. It does not depend on when the cash actually moves around. So, let’s say you earn revenue in December and send an invoice to your customer in December and they pay you in January. On a cash basis, that would be considered January revenue because that’s when it is your bank. On an accrual basis, it’d be December revenue because of when you earned the money. Despite it being the same customer and same sale, the books will look very different. When you compound these differences over time, it can start to matter a lot. Love ya, Mom. Example Scenario Let’s say I’m looking at a small business’s last three years of tax returns, which is filed on a cash basis as most SMBs are. Most people see cash basis as the more conservative way to do accounting. Income comes in at $500K, $500K, and then $1 million in 2025, the year that’s conveniently right before the owner decides to sell. Seeing that jump doesn’t automatically translate to it being a great year in my eyes. Instead, it makes me question how real the growth actually is and whether they are using a cash or accrual basis. To uncover what’s going on, you have to look at the balance sheet. (Fair warning, a lot of SMBs do not show the necessary numbers on the balance sheet to do this analysis properly.) This approach is generally regarded as more efficient than burning down the banana stand. Callback, baby. Here are some numbers to reference before I walk you through what I’m looking for. redactedYou need to look at three accounts on the balance sheet: accounts receivable, inventory, and accounts payable. If a company’s tax return or balance sheet isn’t tracking these, that’s your cue to go find out why. Each account can be thought of as a lever that shifts cash-basis income away from or to what the business actually earned. Accounts receivable If AR decreased by $400K over the year, that means old invoices got collected. Even though plenty of cash showed up, it’s not revenue in that period. It’s just revenue that was already earned in a prior period finally hitting the bank. Cash basis would count for this change as the present year’s income anyway. All that to say, $400K is an overstatement. Inventory If ending inventory decreased by $200K, it means the business used more inventory than it replaced. On an accrual basis, that shows up as COGS going up by $200K. Unfortunately, it doesn’t account for no new cash having left the building to buy it. Accounts payable If the company is delaying payments to vendors, real expenses have been incurred but haven’t hit cash yet. If that gap is $100K, then, on an accrual basis, operating expenses would be $100K higher than the cash-basis numbers suggest. The Bottom Line Once you stack those three adjustments on the business generating $1 million income, the cash-basis year and the accrual picture begin to look very different. Back out the $400K in AR, add the $200K in COGS, add the $100K in OPEX, and EBITDA drops from $1 million to $300K. Just to drive this home: this is a $2.8 million dollar swing on a 4x multiple just by asking what actually changed on the balance sheet. Understanding changes like this one is key to understanding when to kill a deal before it’s too late. Of course, this effect can run the other way too. It’s not always the cash basis that’s inflated; sometimes accrual makes a business look better than the tax return suggests. In either case, the different bases can tell two different stories. If you’re a lender or a buyer trying to figure out whether this business will actually cash flow how you expect it to, only one of those stories tells you what you’re really buying. Tax returns are built for the IRS, not for you. A good rule of thumb is that profit margins and EBITDA margins should be relatively consistent unless there is a reasonable change in the business to explain it. If you’re looking at a deal and want to know which story you’re actually being told, that’s exactly what a quality of earnings report is for. Grab some time with me, and let’s walk through what you could expect your business you are acquiring to actually earn.