By Chris Rowe

Plenty of successful small businesses still operate “out of a cigar box,” where determining if you had a good month is as easy as opening the box to see if there’s any money left in there. Hey, we’re not judging — whatever works for you. But when it comes to selling your business, one of the first things you need to do is get your financials in order.

This entails shoring up your income statement, balance sheet and cash flow statement. It’s crucial to get this “trinity” of financial paperwork in order before going into a sale for several reasons, starting with leaving money on the table. Incomplete or inaccurate financial documents can lower the value of your business, draw out the sale process, and even scare off highly qualified buyers. Let’s dig a little deeper to see how this can play out.

Business Valuation

Accurate financial documents show you how much money your business is making, or losing. Without solid financials, there’s a good chance you don’t have an accurate picture of what’s really going on in your business. And if you don’t have a clear picture, how can a buyer?

Buyers generally base their business valuations on a multiple of cash flow or EBITDA and want to see at least three years of financial statements. Depending on what industry you’re in, this formula may be a multiple of 4-6, 5 -7, or even 8-10 times your cash flow. 

The big question is where your company will fall within that range. If a buyer feels like they’re flying blind due to murky or inaccurate financials, they’ll be less confident making an offer and will increase the risk associated with your business. The higher the perceived risk factor, the lower your valuation is likely to land in your industry range. 

Don’t Raise a Red Flag

When a prospective buyer is ready to make an offer, the first thing they’ll do is scrutinize all of your financials. This step comes before they even think about evaluating production, sales and marketing, research and development, human resources or any number of factors. And if your financials don’t pass the “smell test,” a red flag goes up and they’re likely to look extra close at every other aspect of your business.

You never want to give a buyer any reason to think: If they’re not spending the time and effort to do proper financial accounting, they may not be doing proper equipment maintenance, HR reporting, or even hazardous waste disposal. At best, the buyer will look into every corner of your business with a lot more scrutiny. At worst, you’ll spook the buyer and they’ll walk away. 

Problem Areas to Look Out For

There are a few seemingly innocuous issues that can negatively impact a potential sale more than you might think. Here are a few worth paying extra attention to:

Cost of Goods Sold

Does your company deal with inventory? It pays to carefully evaluate your cost of goods sold. Sometimes the cost of goods sold is simply identified as the amount you spend on raw materials. A more accurate picture includes not only the raw materials, but the labor that goes into making the products, along with the overhead involved. While an anemic cost of goods sold may initially appear to inflate your gross margins, a seller will see past the omissions and adjust the numbers down, which can be an unwelcome surprise. 

Inventory

Another important factor that plays into your cost of goods sold is inventory. Many businesses fail to take inventory on a regular basis and may simply apply a standard cost of materials or estimate cost of goods sold, overstating inventory and understating profitability. Infrequent physical inventory tracking can lead to a significant inventory adjustment. Consider the current inflation rate. If you purchased inventory a year ago, its value has likely increased significantly due to inflation. It’s important to adjust your inventory costs on a regular basis in order to account for price fluctuations and maintain an accurate cost of goods sold.

Accrued Expenses

Proper accrual accounting is important for necessary expenses such as general liability insurance, vacation and payroll liabilities. If you book your expenses only when you pay them and do not spread them over the period they cover, it can negatively affect your income statement.

How To Shore Up Your Financials

The first step to shoring up your financials before a sale is to start keeping up with the basics, from regular physical inventory tracking to monthly bank reconciliations. Beyond that, it’s time to get reviewed or audited financial statements or hire a third party CPA. Consider a professional outside of your regular accounting firm. In many cases, accountants may simply take whatever you give them and apply the proper tax treatment and percentages. That can lead to a scenario sometimes referred to as, “garbage in, garbage out.”

Hiring someone with fresh eyes will provide an objective look at your accounting systems and reports. You want an accounting professional to take a granular look at how your whole system works throughout the lifecycle of a product, from the time you buy raw materials and record a payable to the time the product goes out the door and an invoice is created.

It’s a good idea to work with a CPA firm that has experience in your specific industry, particularly in audits, so they understand the nuances of your business. They can help you develop a chart of accounts customized to your business, which serves as an invaluable road map of your financial statements. They’ll also identify areas of weakness, and improvements you can make with your current system. 

It also pays to invest in a highly competent controller or chief financial officer. Not only will this help you avoid leaving money on the table come tax time, a competent controller or CFO will understand the systems you put into place, from bank reconciliations to how payables are recorded and accruals are made. 

Why It’s So Important

Getting your financials in order will directly improve the marketability and sale price of your business. It will also save invaluable time in the sales process. We always push for a 60-day maximum closing process, as this transition time can raise questions among employees, customers and vendors. 

However, if you get 45 days into the closing process and a buyer starts to question your financials, the process can drag out. For example, a buyer may find an issue between the inventory valuation and the cost of goods sold. The whole process must then stop while people are sent in to count every nut and bolt, and suddenly your 60-day process will end up being closer to 90 or 100 days. 

A proactive approach to getting your financials in shape will pay off in dividends when you’re ready to sell. Beyond that, it’s simply good business. Consider an airplane pilot sitting in the cockpit. The controls at his fingertips tell him everything he needs to know, from how high the plane is flying to when it will land. Even when it’s cloudy or foggy outside, the pilot knows exactly where he’s going. The same goes for your business. The purpose of having good financials is to enable you to see what’s going on in your business — even when you’re sitting on a sunny beach somewhere.