How to analyze SMB financial statements?

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June 18, 2024

by a searcher from Stanford University in Nova Iorque, NY, Estados Unidos

For beginner buyers who have signed an NDA and are looking at the financial statements, could you recommend any guides to analyzing them? What should you look for in terms of assessing whether the acquisition makes sense? What are the red flags to avoid?

Thanks!

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Reply by a searcher
from The University of Chicago in Chicago, IL, USA
Thank you for the tag, ^redacted‌.
My suggestion is to get a friend with financial experience to walk you through this or to do some analysis with you for the first several reps; there's too much to cover in one post. However, I'll mention a few things I would suggest looking at (in no particular order): 1) revenue trends, including mix by channel, customer, service/product, and any special one-time revenue items and be sure you understand the drivers of each; 2) margin trends, with attention to input costs (e.g., materials, labor, overhead) at both a gross margin and EBITDA level (I suggest making a quick "common-size" income statement which will help you see what percentage of sales each expense item represents and identify variability in the cost structure); 3) speak with the the seller or their accountant about the whole order-to-cash cycle, which can provide useful context for your analysis of all three statements (e.g., knowing things like the time it takes to collect cash after delivery of the service will allow you to make sense of things like why working capital grows as revenue grows); 4) ask the seller to identify one-time expenses, revenues, and personal expenses so you can remove those to see a normalized view of profitability.
If you DM me I am happy to have a conversation to share more.
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Reply by an intermediary
from California State University, Northridge in California, USA
Given that you're at Stanford, I'll assume you have some accounting background. Very briefly, I always want to work with cash basis reports. Without a lot of experience or a competent guide, you'll need to familiarize yourself with the industry standard metrics, ratios, etc. to give the numbers a general reality check. I look for wide variances year-to-year to try and uncover nonrecurring expense, unexplained trends (both internal and external), undisclosed events, etc. and question the seller on every line item that seems questionable or that you don't clearly understand. It's the same process with the both the P&L and the Balance Sheet. At that point, you can complete your recast and make an initial determination of value. Ideally, these financials should match closely with the tax returns! If it's a small, straightforward business, you should be able to make sense of it. If it's complicated or more than a $200K valuation, I suggest a beginner buyer should hire an experienced business broker, CPA or other due diligence assistance. Red flags include (but are not limited to) employees paid as contractors, excessive add-backs for seller's personal expenses, ratios/margins/line items far outside of industry averages, declining revenues or margins, etc.
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