Buying a business? Get the bank statement
Updated: Jun 22, 2020
When I was younger I used to walk into meetings with a lot of knowledge about the involved data and numbers, but I soon realized I often did not have a clear objective that I wanted to achieve. It may seem obvious and trivial, but I bet many readers can think about a recent meeting where they eventually realized they did not have a clear goal in mind.
One of the best teachings I received in my professional career was about getting the most out of deals. In my case, deals happened to be M&A ones (Mergers and Acquisitions), I believe it applies to almost any aspect of decision making.
Almost 10 years ago, the professional who taught me by example showed me that it’s crucial to have our own understanding of the main dynamics we’ll discuss together with a clear objective. That does not mean we should not be open to adapt but, if new data come up, we may be better to just regroup, take our time, and come back with our new and updated target.
One situation the reader may find this useful for is the evaluation of the purchasing of a small and medium business – restaurant, shop, medium-sized manufacturing company, etc …
Working on that kind of negotiation, in some occasions I’ve perceived that one side or the other did not have a clear goal, or s/he was just choosing the best option among what the other party was allowing. Having an objective is also about being able to build a first idea without external influence.
The success of an investment is made of many ingredients, we’ll focus here on the purchasing price; this should allow possible entrepreneurs and investors to walk into a meeting with ideas better defined. While this number - or range - is not easy to find nor unique, we will approach it in terms of Required Return on The Investment (Required ROI) and Actual Return on The Investment (Actual ROI). Say we are purchasing a house, we may have a $300k price-tag and an Actual ROI of $10k after-tax cash flow per year in rent – received or saved. Those numbers would give us a 3% ROI; is that a good deal? If we can find our Required ROI, we can find our acceptable purchasing price by dividing the Actual ROI in $ by the Required ROI in % – anything above it would give us a poor return. Say we are indeed requiring a 3% per year, the $10k above would imply that the $300k price-tag is fair to us.
Required ROI
I think nobody can tell us we are necessarily wrong by accepting 3% like in the example above or requiring at least 5% … it would depend on our alternatives, field of competence, and much more; it feels to me there is some subjectivity in this. Asking professionals, we may even get confused by industry standards like 20% annual return, or the annual long-term market 7 - 8% return … we’d risk not to be able to properly compare those numbers against our 3, 5, or 10%. This number is not easy to determine and any short discussion or formula would be incomplete; I cannot add more on this number which I think each investor has to figure out depending on his / her situation – I think it needs research, discussion, pondering ...
At this point the reader may think this discussion is worthless because missing clear formula and numbers; however, by sticking with this reading through the end, s/he may realize this allows for a clearer starting point for effective evaluation. Ultimately, realizing not to know is maybe the best starting point …
Actual ROI
Let’s move now to the actual cash-flow return from the investment? This is the $10k after-tax cash-flow of the previous example.
We consider here the Actual ROI to be a little more objective than the Required ROI; a famous and successful investor once said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact” – the reader can google it. This statement may be interpreted as saying that some intrinsic dynamics in businesses are tough to improve.
In the example on Real Estate, it may seem relatively easy to evaluate the Actual ROI – we may compare common rent in that area for example. What about a restaurant, a consumer shop, or a medium-sized company? How can we easily determine their potential cash-flow? Sometimes it is similarly easy, sometimes a little less …
Depending on the size of the deal that we are discussing, we may have direct communication with the current owner or have an intermediary between us (e.g. investment bank / independent advisor); we may also receive information in the form of financial statements and financial models. Those documents would likely already reflect the objective of the seller - expenses may have been reclassified, allocated, and capitalized … This applies also to audited financials and, maybe even more, to tax-filing documents. The financials we’d be presented to evaluate the deal would probably respect any standard and official requirement, but different investors may have different thoughts on those numbers. It could be argued that a good investor is somebody able to navigate through the financials s/he is presented and build a personal and effective view of the business.
A document that we could find to be of real use while going after the Actual ROI is the bank statement. This is the raw document that can be downloaded from the online portal of the bank; that list of actual cash transactions in & out of the company together with their actual timing. The bank statement is sometimes neglected and often considered only during a subsequent and almost final due-diligence.
While everything passing through the bank statement should be already reflected in the financial documents, sometimes it can reveal unique characteristics because it cannot (should not) be altered - if you receive an altered bank statement, you may be better to walk out the door. A quick look at the bank information would not show the whole picture, but it could help us raise red-flags and identify peculiarities. Those peculiarities could be of both the business and the current management; this is not trivial if the deal assumes we are retaining the actual management – common in private equity and M&A deals - or we are entering in partnership with it.
Once we compare the bank statement with the financial information, we may find that the claimed potential earnings of the business, let’s say $500k per year, are significantly higher than the actual increase of cash in the bank for the last year, let’s say $250k - here, we could find useful insights like the actual cash during the year, not only at the end. Inquiring, we may be answered that in the last year the business had to sustain exceptional and extraordinary expenses that should not be considered in the evaluation of the business. Going forward with the analysis, we may find that the same business had similar amounts of “extraordinary” expenses at any given year, suggesting us to consider those expenses of the “ordinary type” – since we would have to pay those amounts any year regardless of their changing nature. Again, this should be in some way reflected in the financials, but having seen how those financials are sometimes reworked, I’d rather go for the easy and straightforward way.
Other possible investigations could be conducted on the cash cycle (payments in/out) …
Conclusion
We mentioned above just examples stressing the following concept:
In the last decades, there has been an increasing focus on financial modeling, projections, and so on. This may be ok for professionals and institutional investors which may have to play according to industry standards. For example, an investment fund may find useful to evaluate the business through the same standards it will use to put it back on the market.
I think a small entrepreneur or person looking for a good investment for his/her whole family, should always have a careful and practical look at the cash rather than the stated profit.
At the end of the year s/he will not be able to make a capital-call to investors or easily ask for a financing-line to banks if events happen to be negative. Moreover, if a small entrepreneur wants to take the game to a familiar field, s/he may be better to focus on cash rather than financial modeling.
While an exact rule cannot be found, if we agree that cash needs a special focus, we ought to pay the same attention to its actual document, the bank statement.
Final note: we focused here on small and medium businesses because big ones usually have complex cash-flows and multiple bank accounts, possibly across different countries. Therefore, this approach may be tough to scale effectively and we may need alternative methodologies. That is maybe what financial modeling was originally intended for …
The above post and contents reference an opinion and are for information purposes only. They are not intended to be investment advice. Seek a duly licensed professional for investment advice
Thanks to the Boston Public Library for the picture