It isn’t just about the financials…it’s about understanding operations and strategy
In working on business acquisitions, one sometimes encounters executives with a mindset that the main thing that matters is the financial statements (and that looking at details of business operations is a kind of back-up exercise done only for safety purposes). In this viewpoint “the numbers” (as seen in historical financial statements) are seen as reality and other areas of inquiry are seen as being of second order importance because they concern contingencies or speculating about the future.
This view overlooks the fact that financial statements are not themselves the underlying reality of business operations (although their purpose is to try and describe that reality over time). Accounting as a discipline, and the different accounting standards that have developed over time, are in fact a set of rules for summarising and communicating actual business events. The reality is in fact beneath the accounting statements: it is “who did what when”, “when were products and services sold”, “what expenses were incurred (and when)” and at the end of a period of time, “what has actually happened” (in accounting-speak, was there more or less money and assets (net of liabilities) at the end of the period than at the start). This is the actual world of real events, which almost exclusively happen according to some kind of contract (whether written or more informal). Financial statements are a summary of the reality of operations; to understand the value of a business, one has to understand those operations and forecast them into the future; and the details of actual operations are not communicated in financial statements—they are the real-world details of contract terms, business relationships and operations processes.
This article is part of our multi-part series - A Basic Primer on Selling a Business. See the other parts of this series here.
Financial statements are also inherently backward-looking: they are an attempt to summarise the results of what happened over a period, and to provide a snapshot of assets and liabilities at the end of the period. That is tremendously important, of course: it’s what tells us about the inherent profitability (or not) of business operations (according to a standardised set of reporting principles) and what the past trends have been. And, of course, those financial statements can be projected forward into the future…but that has to be done on assumptions. And to make those assumptions and try to make fair predictions of future events, a buyer has to enquire into the actual operating realities of a business: How long is a key supplier committed for? At what pricing? Can key employees get up and leave at the drop of a hat? What long term payment obligations (like rent or debt repayment) are there? When could a creditor accelerate payment of one of them? How predictable are future sales and to what extent is pricing defined in advance? What are the current trends in the marketplace and how are competitors positioning themselves? All of this kind of information, that is fundamental to assessing the future of a business (and thus its value), comes from understanding all the relationships in the business…and much of those relationship terms are set out in contracts (because contracts by definition tell us things like how long relationships are set for, what each party can do during the relationship, etc.)
So, to value a business, you need to make projections about its future, which will be based on the past, but will be fundamentally shaped by weighing up what can happen in the future (and that is largely, but not entirely) laid out in all kinds of contracts. In addition to assumptions about macro-level industry dynamics, when we make projections about the future we look at existing business relationships and make assumptions about how they might change. And a lot of the information about key business relationships is laid out in contracts. (And, of course, further important information also comes from understanding operating processes and strategy, including the past history and state of relationships with key business partners.)
[DIAGRAM 2 – Relationship of historical financial statements to actual operations, assumptions about the future, and financial forecasts]
Continue reading our multi-part series:
A Basic Primer on Selling A Business
- Part 1 - Why selling any business is a challenging information-sharing process
- Part 2 - Case studies in selling a business as an information-sharing process
- Part 3 - The role of financial statements and the misguided view that they are all that matters
- Part 4 - What are the key stages in the process of selling a business
- Part 5 - How do people value a business?
- Part 6 - What kinds of information will buyers of a business want to see?
- Part 7 - How to handle the “bad news” about a business being sold
- Part 8 - What legal issues will buyers usually be concerned about when reviewing contracts?
- Part 9 - Summary: An Overview of Business Sale Processes