What You Need to Know
There can be a lot of information in the business world about finance, which can be overwhelming and confusing. (In fact, it can be so overwhelming you may turn to one of those “Finance for Dummies” books for clarity.) But it’s really fairly straightforward. Whether you currently run a small business, are thinking of acquiring a smaller company, create a partnership or sell part of your company, there are four important financial statements you need to understand. They are:
- Income Statement
- Balance Sheet
- Cash Flow Statement
- Owner’s Equity Statement
Most often, the goal of a buyer is to obtain financial synergies, gain market share or improve their sales or leadership team. They will carefully review your business’ financial statements since they tell a factual story about a business. Therefore, let’s review each of them from a potential buyer’s perspective.
Income Statements: Income statements demonstrate a company’s profitability for a given period – a month, quarter, year, and so on. The revenue line of the income statement shows the company’s top-line momentum, including capital gains, interest income and sales revenue (gross profit). The expenses show whether or not the company is using its resources properly, and if they are generating more income than they are spending. Net income is determined by the gross profit minus total expenses. An income statement can show financial synergies that can include a variety of things, such as increased revenue from improved market share, decreased overhead costs and expenses related to service, etc.
Balance Sheet: The balance sheet shows a company’s major assets (such as land and equipment), its liabilities – more commonly known as debt – and the owners’ equity accounts. Balance sheets represent a single moment in time resulting from the business activities during the period that’s being evaluated (month, quarter, year, etc.). Most investors will focus on your ratio of total debt to total equity when determining your value. A debt to equity ratio that is too high could jeopardize your company’s ability to attract an investor.
Cash Flow Statement: A cash flow statement is different from the income statement in that it does not account for non-cash income and expenses. The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the cash flow statement covers is chosen by the company—it could be for weeks, months or a year. The cash flow statement reports the cash generated and used in the following categories: Operating Activities (what you do to make money), Investing Activities (what you buy to make money down the road, i.e. property, plant, equipment), or Financing Activities (what you do to hold on to your cash as long as possible, i.e. don’t pay your bills until the day they are due). When a buyer analyzes a cash flow statement, the first concern is to ensure the company has enough cash to cover its payables. A buyer is going to focus on whether or not a company is truly operating “in the black” in order to determine if the acquisition makes good financial sense.
Owner’s Equity Statement: An owners’ equity statement is also known as statement of retained earnings, or a statement of shareholder equity. It is the book value of company assets owned by the shareholders. In a large corporation, this statement could include details about stocks, long-term investments, pensions, and capital gains/losses on all non-liquid investments. In a smaller business, the owner’s equity statement may detail changes in account balances – additions and deductions – for a specific period in time. Owners’ equity contributes to a company’s overall net worth, and is therefore requested by a potential buyer to determine if a purchase makes good financial sense.
The figures within these outlined financial statements – income, balance sheet, cash flow, and owner’s equity – heavily influence any transaction in the alarm industry. If you are on the selling side, prepare these documents as early as possible. If you’re a buyer, you may not receive more than an income statement at first, but as you move along in the negotiation process, it is vital to analyze the remaining three financial statements in detail. For additional information on acquisitions, be sure to download our Acquisition Handbook.