Should financial statements be taken at face value when buying a business

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No. The potential buyer of a business as a whole (or the controlling interest in a business) should have in hand the latest financial statements of the company. The financial statements are the essential point of reference but are just a good point of departure for many questions. For example, are book values good indicators of the current market and replacement values of the company's assets?

Current values usually are close to book values for some assets—marketable securities, accounts receivable, and FIFO-based inventory. On the other hand, book values of LIFO-based inventory, long-term operating assets depreciated by accelerated methods, and land purchased many years ago may be far below current market and replacement values.

Cash is usually a hard number, although a buyer should be aware that there may be some window dressing** Every asset other than cash presents potential valuation problems. For example, a business may not have written off all of its uncollectible accounts receivable. Some of its inventory may be unsalable, but not yet written down. Some of its fixed assets may be obsolete and in fact may have been placed in the mothball fleet, yet these assets may still be on the books.

Some potential or contingent liabilities may not be recorded, such as lawsuits in progress. In short, a buyer probably will have to do some housecleaning on the assets and liabilities of the business, and then start negotiations on the basis of these adjusted amounts.

A potential buyer should also ask to see the internal management profit reports of the business, but management may be reluctant to provide this confidential information. For that

Exceptions to this general rule are when a value has to be put on the stock shares of a privately owned business for estate tax purposes or in a divorce settlement.

Window dressing refers to holding the books open a few days after the close of the year to record cash receipts as if the money had been received by the end of the year, to build up the cash balance reported in its ending balance sheet. Unfortunately, this very questionable practice is tolerated by CPA auditors.

matter, the business may not have a very good management reporting system. The buyer can ask for information about product costs and sales prices to get a rough idea of profit margins. In short, the buyer needs both the external income statements of the business and its internal management information as well.

A business might have certain valuable assets that the buyer wants for the purpose of selling them off, or the buyer may be planning radical changes in the financial structure of the business. There have been cases of a buyer paying less than a company's net cash amount—cash and cash equivalents minus liabilities. In other words, the buyer bought in for less than the immediate liquidation value of the business. This is very rare, of course.

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