Do business buyers really care about historical financial performance!
Of all 8 key drivers of business value, the financial performance of a business is often assumed by business owners to be the most important driver of business value. Arguably this is true as (in some circumstances) business value can be calculated by multiplying the maintainable earnings of the business by the capitalisation rate.
Clearly under this approach the greater the amount of earnings or profits the higher the business value. Typically this is how most business owners think. Buyers on the other hand think differently.
From a buyer’s perspective the historical performance of a business is somewhat irrelevant. Buyers are only really concerned with whether or not the historical revenues and profits can be reliably used as guide to predict its future revenues and profits and ultimately the businesses ability to repay their investment.
Buyers care very little about what happened 3 years ago, they are for more concerned about what is going to happen three years from now! Buyers only care to answer one simple question, when will this business generate enough profits to repay what i pay for the business?
If this is true then why do we care about historical financial performance?
The truth is, nobody has a crystal ball and often the most reliable indicator of the future is some sort of analysis of the past.
Therefore to present a meaningful forecast for the future it is prudent to critically analyse past trading results by adjusting the historical financial performance through the elimination of abnormal, non-recurring, private or discretionary items, etc. The objective of the “normalisation” process is to evaluate what the true earnings potential of the business is for the review period based on the stripped back core business model.
For example as most small businesses are run to minimise profits (and therefore tax) it is necessary to prepare a Pro Forma set of financials for recent financial periods which effectively “looks through” unnecessary and private transactions etc so as to determine what the “true profits” of the business would have been. This might mean adjusting for non-commercial owner salaries, private motor vehicles, inter-entity transactions, accounting policy changes, etc. With the underlying profits of the business model front of mind, we are then able to start the process of predicting the future.
Business valuation experts and business buyers together with their advisors will usually construct their own financial model from which to build a prediction of future earnings. The financial model will attempt to bridge the gap between historical and forecast by developing a number of both positive and negative revenue and profit scenarios which utilise all known current data such as sales contracts, lease agreements, open tenders, customer order books etc. The main objective is this exercise is to apply the ratios and logic of the past to likely future events in an effort to predict the future earnings of the business.
When buyers and their advisors critically evaluate the financial performance of a business either as part of the valuation process or through the due diligence process the general quality of the accounting records is almost as important as the results themselves.
Clarity, transparency, accuracy and adherence to accepted accounting standards is paramount to how buyers will perceive the historical performance results and also bear huge influence over the valuation and negotiations process.
Inconsistent, contentious, or misleading accounting is possibly the greatest killer of trust, value and deals above all other factors. From a buyers perspective, messy accounts, complex inter-entity transactions, changes in accounting policy, non-alignment with ATO records, or contentious treatment of transactions all lead to heightened levels of risk that the past results may not be reflective of the future.
Generally speaking the higher the level of risk about the reliability of future earnings, the more the buyer will discount the earnings of the business which will drag down the business value. Increased risk also leads to greater potential for a buyer to simply walk away from the acquisition.
Poor accounting also speaks volumes for the management of the business with most buyers interpreting poor records as either inability to effectively manage or plain mischief.
Not surprisingly advisor fees also tend to increase in line with the perception of risk. Buyers will be reluctant to pursue an otherwise attractive business if the costs to clarify the true state of earnings become cost prohibitive or time consuming. For many buyers, there’s another business down the road that looks just as good!
The quality of your historical financial records is critical to both the calculation of business value and the business owner’s ability to secure an exit deal. Many business owners seek to improve the credibility of their financial records by engaging a reputable audit firm to conduct a review of their annual performance.
In summary, historical financial performance is a key driver of business value however in order to be meaningful to a buyer, the past results must be as credible as they are a prediction of future earnings.
Watch John Warrillow author of the book Built to Sell explain how financial performance drives business value in the video below.
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