Selling a business doesn’t require years of perfect financial performance. Buyers understand that businesses have strong years, difficult years, unusual expenses, changing customers, and plenty of other complications.
What makes buyers nervous is uncertainty.
When something in the financials doesn’t make sense, a buyer is going to ask questions. If the explanation is clear and supported by the records, the issue may be relatively easy to understand. If the answer creates more questions, however, the buyer may start wondering how much confidence they can place in the financial picture they’ve been given.
That doesn’t mean every financial red flag will kill a deal. It means owners should understand what buyers are likely to question and be prepared to explain what they’re seeing.
Quick Answer
Financial red flags that can concern business buyers include unreliable financial records, poorly supported add-backs, unexplained declines or volatility in revenue and earnings, heavy customer concentration, confusing cash flow, and earnings that depend heavily on the owner’s involvement.
None of these automatically makes a business unsellable. The larger question is whether a buyer can understand the issue, verify the explanation, and feel confident that the company’s reported performance gives them a reasonable picture of what they’re buying.
In This Article
- Can the Buyer Trust Your Financial Records?
- Are Your Add-Backs Easy to Defend?
- Can You Explain Changes in Revenue and Earnings?
- How Much Revenue Depends on a Few Customers?
- Does Cash Flow Match the Company’s Reported Performance?
- Do the Earnings Depend on You Being There?
- Find the Questions Before the Buyer Does
Can the Buyer Trust Your Financial Records?
Before a buyer can decide what a business is worth, they need confidence in the numbers they’re using to evaluate it.
That becomes difficult when financial statements are incomplete, accounts haven’t been reconciled properly, personal and business expenses are mixed together, or internal records don’t line up cleanly with tax returns.
The concern isn’t simply that the bookkeeping could be better. If a buyer can’t confidently establish what the company has actually earned, it becomes harder to determine what those earnings are worth.
This is why clean financial records matter well before due diligence begins. A buyer shouldn’t have to reconstruct the company’s financial history just to understand its performance.
Are Your Add-Backs Easy to Defend?
Add-backs are a normal part of many small business transactions. Certain expenses incurred under the current owner may not continue after the sale, so adjusting earnings to account for legitimate add-backs can provide a more accurate picture of the company’s financial performance.
Problems arise when those adjustments become difficult to justify.
If an owner tries to add back every questionable expense, buyers may begin to wonder whether the adjusted earnings reflect the business they’re actually buying or an overly optimistic version of it.
A good adjustment should have a clear explanation and, where appropriate, supporting documentation. The easier it is for a buyer to understand why an expense won’t continue under new ownership, the easier it is to have a productive conversation about the company’s true earnings.
Can You Explain Changes in Revenue and Earnings?
A decline in revenue isn’t automatically a deal-breaker. Neither is an unusually weak year.
But a buyer will want to know what happened.
Maybe the company deliberately stopped offering a low-margin service. A major customer may have delayed an order. The business might have experienced an industry-wide slowdown or incurred an unusual expense.
Those explanations provide context.
A sustained decline without a convincing explanation is a different matter. The same is true when revenue or earnings swing dramatically from year to year and nobody can clearly explain what drives those changes.
Buyers are trying to determine whether historical performance gives them a reasonable basis for thinking about the future. The less predictable the numbers appear, the more important it becomes to understand why.
How Much Revenue Depends on a Few Customers?
Strong revenue doesn’t always mean low risk.
Imagine that one customer accounts for 40% of a company’s annual sales. The financial statements might look excellent, but a buyer now has another question to consider: What happens if that customer leaves?
Customer concentration doesn’t necessarily mean the relationship is in danger. A large customer may have worked with the company for decades. But from a buyer’s perspective, losing that account could materially change the economics of the business they just purchased.
Owners should understand how much revenue comes from their largest customers and how durable those relationships are. Buyers are interested not only in how much revenue a company generates, but how reliably that revenue can continue after a change in ownership.
Does Cash Flow Match the Company’s Reported Performance?
A company can report healthy earnings and still struggle to generate cash.
There may be perfectly reasonable explanations. Customers may take a long time to pay. The company might need to maintain significant inventory. Working capital requirements, debt obligations, or other demands on cash may absorb money that doesn’t immediately appear obvious from the income statement.
A buyer will want to understand that relationship.
If the company appears highly profitable but is continually short on cash, the question becomes: Where is the money going?
The answer can affect how a buyer thinks about the capital required to operate the company after closing. A business that requires substantial cash to support its normal operations presents a different financial picture than one that readily converts its earnings into available cash.
Do the Earnings Depend on You Being There?
Owner dependence can affect the financial picture in ways that aren’t always obvious.
Suppose an owner works 60 or 70 hours per week, personally handles several important functions, and pays themselves less than it would cost to hire someone else to perform those jobs. The company’s historical earnings may be accurate, but they may not represent what a buyer will experience after taking ownership.
The same issue can arise when family members work for below-market compensation or when the owner performs specialized work that a new owner isn’t qualified or willing to take over.
A buyer has to consider what it will actually cost to replace the work currently being performed. If additional employees or management will be necessary after the sale, those costs can change how the buyer views the company’s earnings.
Find the Questions Before the Buyer Does
The goal isn’t to make every unusual number disappear before selling your business.
It’s to understand what a buyer is going to see.
Take a careful look at several years of financial statements, tax returns, and supporting records. Where did revenue change significantly? Why did margins move? Which expenses require explanation? Which adjustments are you expecting a buyer to accept? How concentrated is the company’s revenue? Are there parts of the financial picture that make perfect sense to you only because you lived through them?
Remember that the buyer didn’t.
A financial issue you can clearly explain and support is generally easier to address than an inconsistency nobody can explain. Finding those questions before a buyer starts asking them gives you time to clean up records, gather documentation, address problems where possible, and prepare a clear explanation where they can’t simply be fixed.
If you’re considering selling your business, Rock Bridge Group can help you look at the company from a buyer’s perspective, identify issues that may come up during a transaction, and prepare for those conversations before you go to market.
Give us a call at 800-395-7653 or contact us online to start the conversation.