Why does accurate accounting matter? Let me tell you a story.
Years ago, I worked with the owners of an insurance agency who planned on selling their business. The company had had a profitable niche, a loyal client base, experienced employees, updated technology, and owned an office building in a prime area of town.
The owners had a lot going in their favor – but you’d never know it from looking at their financial statements. Several factors – from using out-of-date software to hiring inexperienced bookkeepers – had left their accounting records in shambles. The company was making money and had cash in the bank, but their balance sheet and income statement were full of strange accounts with unusual balances. They had misclassified expenses and nonexistent assets and liabilities. At one point, they even asked if they’d be better off just scrapping their old records and starting over! It took some work, but we finally got their books sorted out, putting them on a path to sell their business for the highest price possible.
So why was accurate accounting so crucial for selling the business? Couldn’t the owners just rely on the things they had going for them? It’s possible that they could have found a buyer and even negotiated a decent deal without clean financial statements.
But selling a business is like selling a home or a used car: you can sell it “as is,” or you can put a little effort into presenting it in its best light.
How accurate accounting increases business value
Accurate accounting isn’t just about providing historical information. If you hope to sell your business at some point, it can ensure you can ask for – and receive – real value for your business. Here’s how.
Demonstrates cash flows
If you built your business from the ground up, you likely have an emotional investment in your business as well as a financial one. However, buyers tend to look at a business in a cut-and-dry way. The key factors that most business buyers consider are earnings and cash flow.
Buyers want to know that your business will provide a stream of cash that is predictable and enough to cover operating expenses, debt payments, and provide a return on investment. Buyers are most concerned with the future earnings of your business. Yet the future is difficult to predict with any degree of certainty. They have to rely on historical financial statements – preferably three years’ worth.
Are you hoping to get a better price for your business based on new products in development or other items that should contribute to growth in the future? To support the higher price, you’ll be expected to provide projected financial statements showing how the business might be expected to perform after the sale or when future plans are put into motion.
Those projections will need to be supported by facts, not just assumptions. For example, if you expect demand for one of your products or services to increase, why? And why will your company benefit from this growth in demand rather than the competition? Accurate accounting in your historical financial statements combined with other factual data form the foundation of these projections.
Verifies business assets
While the value of tangible assets is far from the only factor that goes into calculating the value of your company, it is a factor. The verifiable assets of your business, such as real estate, equipment, patents and trademarks, and even customer lists provide value. They can be sold or used elsewhere if the company’s earnings dry up.
Buyers will expect to see a list of all physical assets that will be included in the sale, including purchase prices and current market values. If you’ve been expensing the cost of assets rather than maintaining a schedule of fixed assets, creating this list may take some effort.
This list could be helpful to you as well. If you determine that the value of your business’ assets is similar to the price you’d likely receive through a sale, you may decide that liquidation is a faster and easier route to recovering value from your investment.
Enables meaningful financial ratios
Potential buyers will look at key financial ratios to see how your business compares to industry averages, to other acquisitions they may be considering, and to criteria they have set up for themselves.
Financial ratios help show what the numbers in your financial statements actually mean. For example, they tell a potential buyer what percentage of sales dollars make it to the bottom line. They show how efficiently your business collects receivables. They signal if too much of your cash is going towards debt repayment.
Using inaccurate financials to calculate those ratios can provide misleading information. It can even be a red flag that your numbers have been manipulated. Before you advertise your business for sale, calculate a handful of important financial ratios yourself. Compare them to industry averages to see how you stack up. Then you can present that information to buyers along with your own explanations for how they support the idea that your business is a good opportunity.
Supports your asking price
You wouldn’t put your home up for sale without doing a little research to find out how much it’s worth. You’ll need to do the same before you sell your business. If you’ve been highly involved in your company’s accounting, you may have a sense of its worth. However, the value of a business is greater than the total value of its tangible assets.
Buyers purchase an existing business because it already has everything necessary for successful operation – equipment, location, experienced employees, suppliers, business processes and customers. The whole is worth more than the sum of its parts. But how do you place a value on it?
In some cases, you may need a formal business valuation or an appraisal. Many business owners don’t like the idea of spending money on a business valuation. But guessing at the value of your business is likely to result in either a price that’s unrealistically high and turns potential buyers off. On the flip side, it can result in a price that’s unnecessarily low and keeps you from cashing out at full value.
While there are several different methods for valuing a business, one of the first things an appraiser or a valuation analyst will look at is your financial statements. Without accurate accounting, the analyst has to do extra work to reach an estimated value. Of course, that extra work costs you extra money.
Preparing your business for sale is the most common reason for needing an accurate business valuation. But you might also need one to obtain financing, for estate planning, during litigation, or when converting to an S-Corporation. Ultimately, your financials are how people will judge your business. The numbers tell your story, so it’s not only important that they look good, but that they’re presenting an accurate picture. When you go into a transaction with accurate accounting, you’ll know what to expect and can walk away with the best possible outcome.