IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family businesses. The following blog article has been provided by Jennifer Shelton of Mountain Pacific Bank (https://mp.bank/):
The Power of the Balance Sheet in Business Acquisition Due Diligence and Financing
The business Balance Sheet is often viewed as less significant than a company’s profit and loss statement. Yet it contains information that is critical to understanding the financial health and tangible value of the business you are buying or seeking financing to acquire.
The business Balance Sheet is the snapshot of a business at a moment in time. It provides financial indicators which offer clues on the history of the company and its management.
Think about the last time you had a physical exam or routine lab work. The data points and acceptable ranges of your results provided insights into your physical health and lifestyle choices. Similarly, Balance Sheet data indicates overall financial strength or risks to watch.
Understanding the business Balance Sheet can empower your purchase negotiations and prepare you for the insights your lender sees in the business you are planning to purchase.
As a Commercial Loan Officer and advisor for small business acquisitions, I’ll share some tips on how to read and understand a Balance Sheet to allow for more informed decisions.
To start, let’s review the Basics of a Balance Sheet.
What is a Balance Sheet and why does it Balance?
There are three main components of Balance Sheet:
- Assets – What the business OWNS.
- Liabilities (Debts) – What the business OWES.
- Equity – Total funds invested by the founders and cumulative net profits.
Everything the business owns has been purchased by either Debt or Equity.
That is what makes a Balance Sheet work: Total Assets = Liabilities + Equity.
- Current Assets: This is cash in the bank and anything that is expected to be converted into cash in one year or less, such as accounts receivable and inventory.
TIP: Identify Quality and Quantity. Too much Inventory could indicate sales are declining or there is obsolete inventory. An unusually high balance of Accounts Receivable could indicate poor collection procedures or uncollectable revenue. Calculate Days Outstanding on both Receivable and Inventory accounts, then compare it to Industry Standards.
*Here is the Formula to Measure these on an Annual Basis using 12-month totals.
- Days Sales Outstanding = (Accounts Receivable/Total Sales on Credit) x 365
- Days Inventory Outstanding = (Average Inventory/Cost of Goods Sold) x 365
*Industry Standards can be Accessed through your Lender, CPA, Broker, or Public Library.
- Current Liabilities: This is short-term debt expected to be paid off in less than one year. Examples are trade accounts payable, credit cards, or sales tax payables.
TIP: Check the Current Assets total and compare it to the Current Liabilities total.
Is the company leaning on their vendors and showing high accounts payable balances? Calculate Days Outstanding on Accounts Payable and compare it to Industry Standards.
- Days Payable Outstanding = (Average Accounts Payable/Cost of Goods Sold) x 365
Observe if Current Assets are higher than Current Liabilities. This indicates there is enough cash/liquidity to pay off short-term debt. If total Current Liabilities are higher than Current Assets, the business is likely having cash flow challenges and may be difficult to finance.
Here are two formulas banks use to measure the strength of cash flow and liquidity.
Quick Ratio: This measure looks at Current Assets – Inventory/Current Liabilities. It answers the question of whether the company can pay its short-term bills using only cash, receivables, and marketable securities, excluding inventory which is slower to liquidate.
Current Ratio: Current Assets/Current Liabilities. This shows how many dollars of Current Assets are available to take care of all current debt. Look for a ratio higher than 1:1.
If the result is 1.4 this means the company has $1.40 of current value to cover every $1 of current debt. Industry standards will provide an acceptable range for the type of business.
TIP: Accounts Receivable and Inventory can be pledged as collateral in a financing request. The total collateral value will have a discount rate based on industry and bank policy.
- Total Assets: This will include Current Assets as well as everything else the business owns that you will acquire in your purchase. These are tangible and intangible items that add value to a business. This can be real estate, vehicles, equipment, machinery, furniture & fixtures, intellectual property, goodwill, or leasehold improvements. Total Assets include both current and non-current assets.
- Total Liabilities: This encompasses current and non-current liabilities. Non-current or Long-Term Liabilities are debt the business holds with repayment terms longer than one year such as a term business loan or real estate mortgage. In an Asset Purchase, the new owner is not responsible for the debt. It stays with the seller. In a Stock Purchase, the debt stays with the business, and the new owner is responsible.
TIP: Compare Total Assets to Total Liabilities. Identify Quality and Quantity.
Ensure Total Assets are higher than Total Liabilities. This indicates there is enough value in the business assets to pay off all its obligations. If Total Liabilities are higher than Total Assets, the business will be considered highly leveraged and may be difficult to finance.
TIP: To determine the value in your acquisition offer, consider the current market value of the tangible assets listed on the Balance Sheet rather than the depreciated value, since some assets can be depreciated faster than their useful lives. For Intangible Assets, consider the cost to pay for the same leasehold improvement, IP, or start-up expenses. To assess if the value of Goodwill is reasonable, consider the investment it would take to establish the same level of customer loyalty and brand recognition and consider establishing a non-compete clause (NCC) to be included in your purchase negotiation.
TIP: The collateral value of tangible and intangible assets for a financing request will be based on a discounted rate of the Total Assets on the current business Balance Sheet.
An appraisal of the business will be important in valuing its assets, but the values will be based on the business as a going concern, which is its ability to continue operations and generate future profits, and not on its liquidation value.
- Equity: This consists of the initial funds the owner(s) contributed to the business; along with the balance of continued owner(s) investment or draws; retained earnings, which is the cumulative value of business profits/losses over the life of the business; and the current net profit total.
TIP: Total Equity should be a positive number. If it is negative, it is widely considered that the business has no value to sell other than the discounted value of the tangible assets.
TIP: Total Liabilities should not be significantly higher than Total Equity. It is reasonable for a company to balance debt and equity to fund growth, however once a business starts showing more than $3 or $4 of debt for every $1 of equity, it indicates that the business is struggling; profits could be decreasing, owners could be funding losses, and the business is taking on more debt. If you notice this, it is important to learn more about the situation.
The Balance Sheet is a Powerful Tool for your Acquisition Due Diligence and Financing.
- It allows you to be in a position of Offense vs. Defense: A healthy Balance Sheet with higher liquid assets and low debt provides flexibility for a new owner to play offense in downturns such as acquiring struggling competitors or investing in R&D.
- It supports Creditworthiness & Investment: Lenders and Investors rely on the Balance Sheet to assess the business capacity to meet obligations. A clean and clear Balance Sheet can lead to better loan terms and lower capital costs.
- It offers Risk Management: By understanding the Balance Sheet you can identify financial risks, be proactive about cash flow planning, and avoid future defaults.
Jennifer Shelton is a Commercial Loan Officer at Mountain Pacific Bank with over 15 years of experience helping small businesses meet their financing needs. If you have questions about this article or would like to obtain information related to business financing Ms. Shelton would welcome communication at (425) 249-4102 or [email protected].
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.