Analyzing the Financial Statements: How reliable are the target’s financials?
September 1, 2007
The heart and soul of any business can be found in its financial statements: the balance sheet and the income statement, which is also referred to as the statement of profit and loss (P & L), or the statement of operations. Nobody would be foolish enough to buy a business without examining its financial statements (the books) beforehand. The trick is to understand what you’re looking at. Scan the balance sheet and income statement of Houston Sash & Door, Inc. for a few moments to get a feel for them; we’ll cover most of the entries in depth later.
The first thing that should strike you about Houston Sash & Door’s balance sheet and income statement is that both are prominently labeled “Unaudited.” What does this mean? It doesn’t have anything to do with whether the IRS or anyone else from the government has examined the books. Financial statements are either audited or unaudited depending on the amount of checking and investigating the business’s own accountant performs before releasing them. There are degrees of care that go into unaudited statements. The big difference, however, lies between financial statements that have been audited and those that have not. If you’re planning on buying a closely held business-that is, a business whose shares are not traded on a stock exchange-you’ll most likely be receiving unaudited financials. Most closely held businesses are not required to have their books audited, and the owners of most businesses have no reason to undertake the considerable expense of auditing.
Table 1 Houston Sash & Door, Inc., Balance Sheet, Unaudited
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Nonetheless, there’s all the difference in the world between audited and unaudited financial statements. Here’s an example. Houston Sash & Door’s balance sheet states that as of December 31, 2003, debtors (other than its own officers) owed the company $60,142 on various promissory notes. How did the accountant who prepared the entry know that to be true? Since the balance sheet was unaudited, the accountant probably didn’t.
The accountant might not have actually seen the promissory notes in question. Only if the financial statements were audited could we be relatively certain that as of December 31, 2003, these notes receivable represented true debts. In the course of an audit not only would the accountant have examined the promissory notes but would also have contacted the debtors to make sure the debts were real, hadn’t already been paid, and weren’t subject to some defense or offset that the debtors might claim.
Since Houston Sash & Door is a closely held business, there’s nothing wrong or suspicious about its having unaudited financials. The next question cuts closer: Who prepared them?
There’s no way of telling from a look at Houston Sash & Door’s financial statements whether they were prepared by an independent accountant or by an employee of the business, perhaps even by Houston himself! The lower level of comfort you should have for financials prepared in-house is obvious. If the financials are prepared by someone on the outside, nobody’s job is dependent on making them come out the way the owner wants them to. In those cases where the financials are prepared by an independent accountant, he or she will prepare them with a report letter outlining whether the statement is audited or unaudited. If there’s no report letter, you may well be dealing with financials prepared in-house. There’s little chance you’ll be able to require the owner of a closely held business to have an audit conducted on the books before you buy. But if the books have been prepared inhouse and it looks as if you’re serious about buying the business, you may be successful in requiring that up-to-date financial statements be prepared by an independent accountant as a condition of your closing the sale. If the seller is amenable and time permits, you yourself should select the accountant who will do the work (presumably your accountant, who’ll be preparing the financials regularly after you buy). Who pays the accountant is a matter of negotiation between you and the seller.
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