Reading a balance sheet when you buy a small business

The profit and loss statement gets most of a buyer's attention, and it should: it shows what a company earned over a year. If you're new to it, start with reading a profit and loss statement.

The balance sheet answers a different question. It's a snapshot of a single day: what the company owns, what it owes and the difference between the two. It's shorter, it looks dull, and it's where some of the most useful warnings show up.

The three parts

Every balance sheet has three sections.

Assets are what the company owns or is owed:

• Cash in its bank accounts.
• Accounts receivable: money customers owe for work already done.
• Inventory: parts, materials or products waiting to be used or sold.
• Equipment and vehicles, shown at what they cost minus depreciation (a yearly accounting deduction that spreads the cost over the equipment's life).
• Sometimes a building or land, and smaller items like deposits and prepaid insurance.

Liabilities are what the company owes:

• Accounts payable: bills from suppliers not yet paid.
• Accrued expenses: costs already incurred but not yet paid, like wages earned since the last payday.
• Customer deposits: money customers paid in advance for work not yet done.
• Credit cards, lines of credit and loans on equipment, vehicles or the business itself.

Equity is assets minus liabilities: the owner's stake, on paper.

The two sides always balance: assets equal liabilities plus equity. That's where the name comes from.

One caution: equity isn't what the business is worth. Buyers pay for future earnings, not for the equipment. So a profitable service company with modest equity on paper can still sell for about 3 times a year's owner earnings (profit plus what the owner pays themselves, before loan payments and taxes).

A hypothetical example

Here's a balance sheet for a hypothetical plumbing company with about $1.4 million a year in revenue, as of December 31:

What it owns	Amount
Cash	$85,000
Accounts receivable	$140,000
Inventory (parts in the shop and on trucks)	$45,000
Vans and equipment, after depreciation	$120,000
Total assets	$390,000

What it owes, and the owner's stake	Amount
Accounts payable	$60,000
Wages and payroll taxes owed	$25,000
Customer deposits	$30,000
Credit card	$15,000
Line of credit	$50,000
Van loans	$90,000
Total liabilities	$270,000
Equity	$120,000

Read it the way a careful buyer would:

• Can it pay its near-term bills? Cash, receivables and inventory add up to $270,000. What it owes in the near term (payables, wages, the credit card, the line of credit and work customers have paid for) adds up to $180,000. That's still a comfortable gap. That's a comfortable gap.
• How fast do customers pay? Divide receivables by a year's revenue and multiply by 365: $140,000 divided by $1.4 million, times 365, is about 37 days. Compare that with the company's payment terms and with earlier years.
• What's owed in work, not money? The $30,000 in deposits is work customers have already paid for. Whoever owns the company after the sale has to do it.
• Is the line of credit a tool or a crutch? Ask how the balance moves during the year. A line that's paid down after the busy season is normal. One that sits near its limit all year can mean the company is short of cash.

What to look for

Cash that doesn't match the profits. If the profit and loss statement shows healthy profits but cash stays low year after year, find out where the money goes. Common answers are owner withdrawals, loan payments and equipment purchases. All can be fine. You just want to know.

Receivables growing faster than sales. It can mean customers are paying more slowly, or that some of those invoices will never be paid. Ask for an aging report, a list of who owes money and how long each bill has been open. Anything unpaid for many months deserves a question.

Inventory that may not be real or useful. Old parts for equipment nobody uses anymore can still show up at full cost. Before a purchase, someone should count the inventory and look at what it is.

Equipment at book value. The figure on the balance sheet is cost minus depreciation, not what the equipment is worth or how long it will last. A fully depreciated van may still run well, or be about to need replacing. You'll need to look at the equipment itself.

Debts you didn't know about. Every loan, line of credit and equipment lease should appear somewhere. Check them against the list of debts the seller gives you, and against the interest expense on the profit and loss statement.

Unpaid payroll taxes or sales taxes. A balance owed to a tax agency that keeps growing is a serious warning. Ask about it directly, and have your accountant look.

Money moving between the owner and the company. Lines like "due from shareholder" or "loan to owner" mean money went from the company to the owner, or the other way, outside of normal pay. It's common in small companies. Ask what it is and how it will be settled before a sale.

Equity shrinking while profits grow. If the company reports profits but equity keeps falling, the owner is usually taking out more than the company earns. If not, something on the profit and loss statement isn't telling the whole story.

Look at more than one year

A single balance sheet is a photograph. Three year-end balance sheets, plus a current one, start to show a story. Put them side by side and look at the direction of each line: cash, receivables, debt, equity. Ask about anything that changed sharply.

Where to find the balance sheet

• Ask the owner for year-end balance sheets for the last three years and one as of the latest month.
• Check the tax returns. Most corporation and partnership tax returns include a balance sheet called Schedule L, though very small companies can skip it. The IRS instructions say it should agree with the company's books. Compare it with the balance sheet the owner gives you. A sole owner who reports on Schedule C has no balance sheet on the return.
• Ask how the books are kept. Many small companies keep their books on a cash basis, recording income when it's received and costs when they're paid. Their balance sheets may leave out receivables and payables entirely, so ask for those lists separately.

What the balance sheet means for your offer

When you buy a small company, you usually don't take everything on its balance sheet. In many purchases the seller keeps the cash and pays off the company's loans at or before closing, and the buyer takes the equipment, the customer relationships and enough working capital to keep running. Exactly what stays and what goes is negotiated, and your attorney and accountant will spell it out in the purchase agreement. Reading the balance sheet early helps you ask for the right things.

What to do this week

• Put three year-end balance sheets side by side in a spreadsheet, one column per year.
• Work out how many days customers take to pay, for each year.
• List every liability and ask who will pay it at closing.
• Mark anything that changed sharply and turn each one into a question for the owner.
• Have an accountant who works on business purchases look over your notes.