black baker tilly logo

Pre-Sale Processes: 4 Tips for Standardizing Financial Statements

We are together in each step

The primary focus for business owners is often on minimizing taxes and maximizing benefits for themselves and their families. This often involves tactics such as maximizing perks and benefits, employing family members, and deducting various expenses through the business. While standardizing financial statements can help reduce taxes and increase personal benefits, they can also impact the true value of the business, especially when it comes to true value of the business,, especially when it comes to business valuation.

Financial statements play a pivotal role in Business Valuation, serving as the foundation upon which the assessment is built. However, these statements often need to undergo a process known as standardarizing or adjustment to reflect the true earning capacity of the business. Standardizing financial statements involves making a series of adjustments to the financial statements to eliminate owner-specific perks, benefits, and expenses, thereby showcasing the actual available cash flow of the business.

Reminder: Distinction between EBITDA and Cash Flow

It's important to note that EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and Cash Flow are not the same. While EBITDA serves as a useful measure for assessing operational performance, cash flow reflects actual income and expenses, including changes in working capital and investments. When making financial adjustments, keep this distinction in mind to provide an accurate picture of your company's financial situation.

Types of Adjustments in Standardizing Financial Statements

During the process of standardizing financial statements, various adjustments are undertaken to ensure an accurate depiction of the business's earning capacity. These adjustments play a crucial role in eliminating distortions caused by non-recurring events or owner-specific expenses. Below are the key types of adjustments commonly made:

1. Discretionary Expenses:Discretionary expenses encompass costs incurred by the business that primarily serve the personal benefit of the owner rather than contributing directly to business operations or employee welfare. Examples include extravagant entertainment expenses, luxury travel arrangements, or high-end personal perks provided by the business. By identifying and excluding these expenses, the financial statements reflect a more realistic picture of the business's operational costs and profitability.

2. Extraordinary Expenses: Extraordinary expenses refer to one-time or infrequent costs that are exceptional in nature and unlikely to recur in the normal course of business operations. These expenses may arise from unforeseen eventssuch as natural disasters, legal disputes, or significant write-offs. By segregating and adjusting for these expenses, the by standardizing financial statements we provide a clearer view of the business's ongoing operational performance, free from the distortions caused by extraordinary events.

3. Non-Operating Revenue and Expenses:Non-operating revenue and expenses encompass financial transactions that are unrelated to the core business activities and do not contribute directly to generating income or supporting operational objectives. Examples include interest income from investments, gains or losses from asset sales, or proceeds from insurance settlements. By excluding these non-operational items, the adjusted financial statements focus solely on the business's core operating performance, facilitating a more accurate assessment of its profitability and financial health.

4. Non-Recurring Revenue and Expenses:Non-recurring revenue and expenses are items that occur irregularly or infrequently and are not expected to impact the business's financial performance on an ongoing basis. These may include one-time expenses such as major capital expenditures, restructuring costs, or windfall gains from asset sales. By adjusting for these non-recurring items, the financial statements provide a normalized view of the business's earnings potential and underlying operational efficiency, enabling stakeholders to make informed decisions based on sustainable financial metrics.

Standardizing Financial Statements

Tips for Making Adjustments

Making accurate and appropriate adjustments to financial statements is crucial for ensuring transparency and credibility during the business valuation process. Here are some tips for making effective adjustments:

1. Thorough Documentation: Providing comprehensive documentation for each adjustment is essential to substantiate its validity and accuracy. Detailed records, such as invoices, receipts, contracts, and supporting data, strengthen the credibility of the adjustments and instill trust in potential buyers.

2. Embrace Conservatism: Adopting a conservative approach when making adjustments is crucial to avoid exaggerating the business's earning capacity. By erring on the side of caution, you mitigate the risk of skepticism from buyers and foster an environment of trust and confidence in the financial information presented.

3. Minimize Adjustments:Strive to minimize the total number of adjustments, focusing primarily on significant expenses that materially impact the business's cash flow. By prioritizing essential adjustments and avoiding trivial or negligible items, you streamline the valuation process and enhance clarity for potential buyers.

4. Maintain Transparency: Transparency is key to building trust with potential buyers . Clearly communicate the rationale behind each adjustment and provide ample opportunity for buyers to review and verify the adjustments independently. Openness and honesty in financial reporting contribute to establishing trust and credibility, facilitating smoother negotiations and transactions.

How to Easily Produce a Detailed List of Adjustments

To efficiently generate a detailed list of adjustments, follow these steps:

1. Export the Profit and Loss (P&L) Statement: Export a detailed profit and loss statement from your accounting software to a spreadsheet program like Excel. This report should include each transaction individually for accuracy.

2. Identify and Mark Adjustments: Carefully review each transaction in the profit and loss statement to identify items requiring adjustment. Mark each adjustment directly in the spreadsheet, either by adding an additional column or highlighting the corresponding rows.

3. Provide Supporting Documentation: Ensure you have supporting documentation available for each adjustment, such as invoices, receipts, or contracts, to validate the necessity of each adjustment.

4. Review and Finalize: Conduct a thorough review of the adjustments to ensure accuracy and completeness before presenting the list to potential buyers or stakeholders. Once satisfied with the accuracy of the list, finalize it for distribution.

Maximizing Business Value through Financial Standarization

al statements serves as a pivotal step in the precise Valuation of a business. By diligently making essential adjustments to portray the genuine earning potential of the business, sellers significantly enhance transparency, credibility, and ultimately, optimize the value of their business during a sale.

Adhering to best practices throughout this process, such as being thorough in identifying adjustments, conservative in estimating values, and meticulously documenting all transactions, ensures that potential buyers receive accurate and reliable financial information. Moreover, maintaining transparency and integrity in financial reporting not only instills confidence in potential buyers but also fosters smoother negotiations and transactions.

Ultimately, a well-normalized set of financial statements not only reflects the true financial health of the business but also contributes to achieving the best possible outcome for both the seller and the buyer in the sales process.