The Importance of Past Performance & Reliable Financials
While you need to value the assets of a business, past profits are often the best indicator of the business' overall value, says Wise. You can use past profits to predict future earnings, by looking at the current and past financial statements. However, Wise cautions, the financial statements will only show the assets at the original historical cost, and wouldn't be adjusted for things like inflation.
"Accounting will show what it actually is, valuation will adjust it to show what it normally should be in the real world. A business valuator has to go through each and every item on these statements to look for a normalized economic level of expense outside of the financial statements."
Wise explains that after all is said and done only hindsight will really tell you if you made the right decision in buying a business. Doing all of your homework and looking at absolutely every aspect of the business can lower risk.
"There are no guarantees, the future economy is unknown. You really have to kick the tires when valuating a business."
The cost of financials vs. the reliability of the information
To assign a final dollar value to the business, you need to review past and current financial statements. This can be easier said than done. For most businesses, the time has call in your accountant for help.
Brad Miehls, a Chartered Accountant with Hyatt Lassaline in Windsor, ON explains that there are three types of statements that can be prepared when reviewing a business. In essence, the difference between the three types involves the amount of detail in the review, and correspondingly, the cost.
A Notice to Reader Statement is the quickest and cheapest type of financial review. When your accountant does a notice to reader, he or she simply takes the numbers recorded by the company's current bookkeeper, and puts them into a generic financial statement that conforms to Canadian standards.
With a Review Engagement Report, which is more thorough and reliable than the Notice to Reader, your accountant will look for unusual changes in profit and budget, as well as trends. “The final result is that we will give assurance to the reader that we did not find anything wrong or very unusual,” says Miehls.
An Audit is your most comprehensive and expensive choice. At this point the accountant is going over each number with a fine tooth comb. However, in the end you can be completely confident that the statements are correct. “Because we're saying that the numbers, we feel, are correct we have to do a lot more work with regards to understanding the systems in place.”
For a small business that is earning under a million dollars in sales, Miehls doesn't recommend an audit because it can be very expensive. “A Notice to Reader shouldn't be relied on. With a review at least you've looked for irregularities.”
If the seller has a problem handing over the financial statements they can ask for confidentiality agreements stating that no one can see the information without the owner's approval. Miehls feels that it's a good idea for buyers to ask for these agreements.
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