Look Carefully at Issues, Numbers Behind Financials

(Originally published in The Business Journal)

Valuation is critical when considering the acquisition of a company. Most valuation methods used to determine the value of a business are based, at least to some extent, on information contained in the target company’s financial statements.

But financial statements could conceal information that can be uncovered only through careful follow-up inquiries. Understanding what is behind the numbers in financial statements becomes very important in an acquisition context.

The three major financial statements from which valuations are drawn are the income statement, balance sheet and statement of cash flows. The income statement and balance sheet are particularly susceptible to legal yet deceptive “massaging” of their numbers.

For example, the sales or revenue line of an income statement is the basis from which the rest of the statement is drafted. However, not all sales reflected in the statement may actually be finalized. If certain sales are contingent on events that never come to fruition, the company’s net income will be overstated in the income statement.

Other potential pitfalls that could be concealed in financial statements include:

Discounts. This marketing technique may inflate sales in the short term while demand is actually waning.

Relaxed credit standards. This could lead to an increase in sales on the income statement but result in uncollectible receivables as time goes on.

One-time sales. An income statement may contain certain one-time gains or sales arising out of the disposal of assets that are not related to the company’s primary business. This can artificially inflate a company’s bottom line.

Inadequate cash flow

A good litmus test of company earnings is to compare net income to cash flow from operations on the statement of cash flows. Cash flow from operations should generally correlate with net income. If increases in net income are not reflected in the company’s cash collections over an extended period of time, it’s likely that the company is inflating earnings on its income statement.

Inflated asset values

Numbers can also be “massaged” on a company’s balance sheet. For example, a company may keep obsolete inventory on its balance sheet, or overstate its work in progress, resulting in inflated asset values.

Questionable receivables

Likewise, receivables can be inflated by neglecting to account accurately for their allotted uncollectible portions.

Prepaid expenses

These can be deceiving at first glance as well. Prepaid expenses are listed as assets on a company’s balance sheet where the expense has been paid but will be incurred later. Such prepaid expenses could include insurance, rent or marketing that have been paid in advance but are actually considered part of the everyday operating expense of the business.

Asset depreciation

This number can be deceiving as well, as companies have a variety of methods at their disposal for calculating it. Depreciation also affects both the income statement and the balance sheet. When analyzing a company’s financial statements, it is important to understand which assets are being depreciated and what method(s) the company employs.

Liquid asset volatility

Beware of a company’s investments in securities or other very liquid assets as they are typically volatile and their values may change from day to day. The volatility of these assets is particularly important because the balance sheet shows the value of a company’s assets at a specific point in time. The older the balance sheet is, the more likely it is that these items’ values have changed.Off-balance sheet items. Finally, be wary of unreported balance sheet items. These items may include, among other things, unfunded pension obligations and pending lawsuits, which can result in significant future liabilities.

Careful inquiries about the components of a company’s income statement, balance sheet and statement of cash flows may be necessary to develop a more accurate picture of a company’s financial condition.

This attention to detail will assist an acquirer in establishing the true value of a target company.