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Buying and Selling a Small Business - Chapter 4 - Sources of Financial

BOTH BUYER AND SELLER are interested in financial information, affecting the
buy-sell transaction. However, since the seller already has this information, it is a
major requirement for the buyer to get and make use of as much of it as possible.
The buyer can usually find financial information in the following places: (1) financial
statements, (2) income-tax returns, (3) other internal records, and (4) other external
Financial Statements
The results of the financial transactions of every company should be reflected in its
periodic financial statements. These statements are extremely important in buying or
selling a small business. They were prepared for the seller, of course, and their
contents are available to him. But the buyer, too, should be aware during the early
stages of a buy-sell transaction of the information contained in financial statements.
Balance sheet and income statement. The balance sheet is a statement of the financial
position of the business at a given moment in time. The income statement is a
summary of the revenue and expenses of the business during a specified period of
time. These financial statements show only the past results of the company's
transactions. The results of future operations may or may not be similar.
Balance sheets and income statements in themselves contain important information,
but they are most useful when a professional accountant makes a detailed analysis of
them. A complete analysis includes a review of the manner in which the statements
were prepared, and perhaps also a review of the records and control features of the
accounting system. This is especially important in a small business buy-sell
transaction because the financial statements of smaller companies are not usually as
professionally prepared as the statements for larger companies. An accountant should
be brought into the buy-sell transaction as early as possible by the seller as well as by
the buyer.
Audited statements. In many buy-sell transactions, the statements are supplied by the
seller, but the buyer reserves the right to conduct an audit of the seller's records. Or
the buyer insists that the seller "warrant" his financial statements. Warranty of
financial statements by the seller should be accepted with caution, however, because
there does not seem to be any uniform definition of the term warranty.

If the seller's financial statements are prepared by an independent accountant, the

statements should show whether they were (1) prepared after an audit of the seller's
accounts, or (2) prepared from the seller's records without verification by audit. If they
were prepared without verification by audit, they may be quite similar or even
identical to statements that would have been prepared by the seller's own bookkeeper.
If they were prepared after an audit, they should include a statement of the
accountant's opinion.
Financial statements prepared without such an audit may or may not reflect the
financial position or results of operation of the company. Most small companies do
not have their records audited annually, but without an audit it is impossible to tell
how accurate the statements really are.
Other considerations. The buyer should request balance sheets and income statements
for at least 3 and preferably 10 years. If the seller is a new company, financial
statements for the entire life of the company should be requested.
Other financial statements are sometimes available to the buyer. These include such
items as statements of cost of goods manufactured (if the seller is a manufacturer),
application of funds, and variances from the budget.
Another point the buyer should consider is the cutoff period for the financial
statements. The statements may have been cut off during the low period of the sales
cycle or during the high period. This has some bearing on the financial position
reflected in the statements.
More detailed information on financial statements and their analysis is given in
chapters 9, 10, and 11.
Income-Tax Returns
If independent accountants did not prepare the financial statements, the seller may or
may not have complete sets of statements. He should have at least an annual income
statement--that much is required for income-tax purposes. If the seller is a partnership
or corporation, the tax returns should have balance sheets attached. If the seller is a
sole proprietorship, tax returns will not show balance-sheet data.
Financial statements prepared for income-tax purposes may be very different from
statements prepared in conformity with generally accepted accounting principles.
Those prepared for tax returns are designed to present the desired tax position in
compliance with the income-tax laws. Financial statements for nontax purposes have
different objectives and therefore may reflect different financial information.

Many small companies prepare financial statements only for income-tax purposes and
use those statements for all management decisions. This may or may not give the
desired results. The parties to a buy-sell transaction are interested in statements
reflecting the tax position, but they should concern themselves also with statements
reflecting nontax items.
The buyer should request copies of tax returns for at least 3 and preferably 10 years
or, if the seller is a new company, for the life of the company. The tax returns are more
important in buying the stock of a corporation than in buying the assets of a
corporation, partnership, or sole proprietorship.
The corporation is an income-tax entity; the partnership and sole proprietorship are
not. A partnership is required to file income-tax information returns but does not pay
income taxes as a company--the taxable income is passed on to the partners, and they
pay the tax as individuals. No tax return is filed for a sole proprietorship, but the
income statement is included as a part of the sole proprietor's personal income-tax
The buyer should find out which tax returns have been examined by the Internal
Revenue Service and which have not. This is particularly important if the buyer is
purchasing the stock of a corporation. If a corporation with an operating loss is being
acquired, the loss might have value and the buyer should satisfy himself as to whether
this net operating loss can be utilized. In many instances, the only information
available to the buyer is that found with the income-tax returns.
Other Internal Sources
The financial statements are usually supported by detailed analyses of selected
accounts. This might include some of the following items:
Sales may have been analyzed by customer, product, division, salesman, time period,
and any other classifications necessary.
Purchases may be classified according to product, time period, territory, supplier, or
other classification. If the seller is a manufacturer, he may have cost-control reports
that include analyses of material costs, labor costs, overhead cost, scrap sales, spoiled
and defective goods, and other items.
There may be a cash-flow statement--perhaps incorporated with the analysis of
collections of accounts receivable--and even a projection of cash requirements.

The seller may have a regular budgeting program with projections into the near or
distant future. It is common practice for the buyer to require the seller to make a
projection for at least a year from the date of the proposed transfer. The buyer should
insist on this projection.
Other External Sources
The seller's suppliers are an excellent source of information for the buyer. They can
provide records showing the volume of purchases by the seller. This information may
be difficult to get in some cases, particularly if the seller informs his suppliers that it is
proprietary information.
Another source of data is the seller's banker. A banker can supply information about
cash position, line of credit, and other fiscal data. He may, however, be reluctant to
release this information.
The seller may have filed payroll-tax reports, sales-tax reports, excise-tax reports, ICC
reports, or any of many other government reports. Some of this information is
available to a buyer.
The buyer may seek information about the seller from credit agencies or credit
associations related to trade associations. Usually, the buyer must have a contact with
these agencies in order to get the information, but there are many ways to get reports
about the seller.
A number of organizations, including trade associations, supply information about
industry averages. These averages are very important to the buyer for judging the
effectiveness of the seller.
Advice to the Seller
The seller, for his part, should be cautious about releasing information to the buyer. It
is entirely possible that the supposed buyer is a competitor, or may be one in the
future. Often a seller is so anxious to sell that he supplies any information requested
by the buyer without even getting a good-faith deposit. He may spend many dollars in
collecting the data for the buyer. A seller should not supply any information to anyone
without first discussing the matter with his accountant and his attorney.