How to Read Financial Statements When Buying a Business

I have spent most of my career around businesses without being an accountant.

That is probably a useful place to start this article.

If I am looking at buying a $2 million or $3 million private company, I am absolutely going to have an accountant involved. I want proper financial due diligence. I want tax returns reconciled. I want someone who understands transaction accounting looking at the details I do not know enough to challenge.

But I do not want my accountant to be the first person who understands the business.

If I am going to own the company, borrow against it, guarantee some of the debt and possibly spend the next decade running it, I need to be able to open the financial statements myself and understand what they are trying to tell me.

Not every accounting rule.

Not every tax provision.

The business.

That is a different skill.

A financial statement is not just a report card. It is a compressed history of thousands of operating decisions: what customers bought, how much margin the company kept, how quickly customers paid, how much inventory management needed, what equipment wore out, how aggressively the owner withdrew cash and how much capital had to remain trapped inside the business.

BDC describes the core financial statements as the balance sheet, income statement, cash flow statement and statement of retained earnings. The income statement measures profitability over a period; the balance sheet shows what the company owns and owes at a point in time; the cash flow statement shows where cash came from and where it went. Those statements are linked, not independent documents.

For an acquisition buyer, I think of them even more simply:

The income statement tells me what the business says it earned. The balance sheet tells me what it needed to earn it. The cash flow statement tells me whether the earnings actually became cash.

And the notes tell me where some of the bodies are buried.

That is where I would start.

I Am Not Trying to Become an Accountant

There is a temptation with financial statements to learn the vocabulary and mistake that for understanding.

Current assets.

Current liabilities.

Retained earnings.

Amortization.

Accrued expenses.

Shareholder loans.

Wonderful.

I can memorize definitions.

That still does not tell me whether I should write a $600,000 equity cheque for the company.

When I read acquisition financials, I am trying to answer a relatively short list of economic questions:

Are the earnings real?
Are they improving or deteriorating?
How much capital is required to produce them?
How much of the reported profit turns into cash?
What has the owner been taking out?
What liabilities am I inheriting or effectively paying for?
Are assets worth anything close to what the balance sheet implies?
Is the company underinvested?
Is working capital healthy or bloated?
Can the company support acquisition debt?
What happens when the seller leaves?

Those questions are much more important to me than being able to recite every line of a set of financial statements.

The accounting is the language.

I am trying to understand the story.

Start With Three to Five Years, Not One

One year can lie without anyone committing fraud.

A great year can result from one large project.

A bad year can contain a plant shutdown.

Margins can temporarily improve because an owner delayed hiring.

Inventory can be unusually low on the fiscal year-end date.

Receivables can be unusually high because one customer paid a week late.

BDC’s acquisition due-diligence guidance recommends reviewing accountant-prepared year-end statements for at least the past three to five years, along with interim year-to-date statements, the comparable prior-year period, trial balances, forecasts, tax returns, bank statements and detailed records such as customer revenue, product margins, inventory aging and AR/AP aging.

That is much closer to what I want.

I am not buying last year.

I am buying the next five years of cash flow using the previous five as evidence.

The first thing I want to see is the trend.

My First Pass Is Surprisingly Simple

Before I normalize EBITDA or calculate ratios, I would probably spend fifteen minutes looking at five years of statements and asking:

Revenue

Is it growing, flat, declining or volatile?

Gross Profit

Is gross margin stable, improving or deteriorating?

Operating Expenses

Are they growing faster than sales?

Did one category suddenly change?

EBITDA or Operating Profit

Is the business becoming more or less profitable?

Accounts Receivable

Is AR growing faster than revenue?

Inventory

Is inventory growing faster than cost of sales?

Accounts Payable

Is the company stretching suppliers?

Fixed Assets

Is the asset base being replenished or quietly depreciating away?

Debt

Is debt rising, falling or moving around?

Cash

Does the company actually accumulate cash when it reports profit?

That first pass often tells me where to dig.

If sales grew 30% while receivables grew 80%, I have a question.

If EBITDA rose while maintenance spending collapsed, I have a question.

If inventory doubled while revenue was flat, I have several questions.

The statements become interesting when they disagree with each other.

The Income Statement: What Did the Business Earn?

The income statement is the easiest statement to understand and probably the easiest one to overvalue.

BDC defines it as the statement showing what a company earns, what it spends and whether it makes a profit over a period.

At a basic level:

Revenue – Expenses = Profit

For an acquisition, I usually work down the income statement in layers.

Revenue Is the Beginning, Not the Answer

Suppose I see:

Year	Revenue
2022	$4.0M
2023	$4.3M
2024	$4.6M
2025	$5.0M
2026	$5.4M

That looks excellent.

Five years of steady growth.

But I immediately want to know:

Where did it come from?

Perhaps one customer went from $300,000 to $1.5 million.

Perhaps prices increased 25% while unit volume barely changed.

Perhaps the company acquired a product line.

Perhaps a competitor went out of business.

Perhaps the seller won a contract that expires six months after closing.

The income statement tells me sales increased.

It does not tell me the quality of the increase.

This is why BDC’s acquisition due-diligence list goes beyond the financial statements themselves and calls for revenue by customer and product-margin information.

The general ledger and customer detail explain the headline.

Revenue is evidence.

Revenue composition is diligence.

Gross Margin Is Often More Interesting Than Revenue

Suppose revenue rises:

$4.0M → $5.4M

But gross margin falls:

35% → 28%

Gross profit moves from:

$1.40M → $1.51M

The company added $1.4 million of sales and only $112,000 of gross profit.

That is a very different growth story.

Maybe the company chased low-margin work.

Maybe material costs rose and pricing lagged.

Maybe the sales mix changed.

Maybe a major customer negotiated harder.

Maybe the accounting classification changed.

I would want to understand it.

In industrial companies especially, I care enormously about gross margin because it tells me something about pricing power, product mix and operating discipline before overhead muddies the picture.

A growing company with collapsing gross margin can be getting worse while the top line gets prettier.

Then I Look at Operating Expenses

This is where private-company financial statements start getting personal.

A public company has shareholders.

A small private company has Bob.

Bob owns the building.

Bob’s wife does bookkeeping.

Bob’s truck is in the company.

Bob’s golf membership may be in the company.

Bob pays himself $70,000 even though replacing him costs $180,000.

Bob’s daughter works summers.

Bob had a $90,000 legal dispute last year.

Bob may also be running an exceptionally disciplined company with almost no waste.

The income statement reflects the business as Bob chose to operate it.

I need the business as I will have to operate it.

That is the normalization exercise.

This Is Where SDE and EBITDA Come Back

I have already gone deeply into SDE vs EBITDA and what a Canadian business buyer is actually buying.

The short version is that reported earnings are not necessarily buyer earnings.

If the seller works full time and adds his compensation back to create SDE, I need to decide who performs that work after closing.

If it is me, part of the SDE is compensation for my labour.

If I want the business to operate independently, I need to subtract a market replacement salary.

Likewise, every add-back needs a simple test:

Will this expense actually disappear after I own the company?

If not, it is not an add-back for me.

This is why I would never read the income statement only down to the seller’s advertised EBITDA and stop.

I want to rebuild the earnings myself.

Five Years of Margin Tells Me More Than Five Years of Profit

Suppose:

Year	Revenue	EBITDA	EBITDA Margin
2022	$4.0M	$440K	11.0%
2023	$4.3M	$473K	11.0%
2024	$4.6M	$483K	10.5%
2025	$5.0M	$475K	9.5%
2026	$5.4M	$459K	8.5%

A broker can say:

Revenue has grown 35% in five years.

True.

The company makes slightly more EBITDA too.

Also true.

But the business is becoming less efficient with every dollar of revenue.

That matters.

Maybe there is an easy operational improvement.

Or maybe the competitive position is deteriorating.

Either way, I would not apply a multiple to $459,000 until I understood why $5.4 million of sales now produces less margin than $4 million used to.

Net Income Is Not the Number I Would Value the Business On

Net income includes things that can be heavily affected by the seller’s capital structure and tax situation:

interest,
depreciation,
amortization,
taxes.

That makes it useful but not directly comparable between different ownership structures.

This is one reason EBITDA is so common in acquisitions.

But net income still matters.

If EBITDA is consistently $600,000 and net income is $40,000, I want to know why.

Perhaps there is enormous depreciation because the company owns expensive productive equipment.

Perhaps interest expense is crushing it.

Perhaps there are unusual expenses.

Perhaps the EBITDA normalization is fantasy.

I do not throw away net income because I prefer EBITDA.

I reconcile the difference.

The Balance Sheet: What Did It Take to Produce Those Earnings?

This is where I think acquisition analysis becomes much more interesting.

BDC defines the balance sheet through the standard equation:

Assets = Liabilities + Shareholders’ Equity

It is a snapshot at a specific date.

The income statement might tell me a company generated $500,000 of EBITDA.

The balance sheet may tell me it needed:

$900,000 of receivables,
$1.2 million of inventory,
$2 million of equipment,

to do it.

Another $500,000 EBITDA company may need:

$250,000 receivables,
no inventory,
$50,000 equipment.

Those are not the same economic asset.

They merely produce the same EBITDA.

Cash: Useful, but Usually Not Mine

A seller may have accumulated $1 million of cash in the company.

Lovely.

In a typical cash-free, debt-free acquisition, that excess cash is generally for the seller, not me, subject to the actual transaction terms.

I care about cash for two reasons.

First, historical cash accumulation helps tell me whether profits converted into cash.

Second, I need to understand the post-closing liquidity position.

I do not want to admire a company that historically operated with $1 million of cash and then acquire it with $75,000 left in the bank and a new acquisition loan.

The historical balance sheet is not necessarily the balance sheet I will inherit.

That distinction matters throughout the statement.

Accounts Receivable: Revenue That Has Not Become Money Yet

Accounts receivable is one of my favourite balance-sheet lines because it connects sales to cash.

The company has booked revenue.

The customer has not paid.

BDC’s acquisition guidance specifically recommends reviewing receivables aging and looking for slow-paying customers.

The basic average collection period is:

Average Accounts Receivable ÷ Net Credit Sales × Days in Period

Suppose:

annual credit sales: $5 million
average AR: $500,000

Collection period:

36.5 days

Now suppose next year:

sales: $5.2 million
AR: $900,000

Collection period:

63.2 days

Sales increased 4%.

Receivables increased 80%.

Something happened.

Maybe a large customer has 90-day terms.

Maybe collections deteriorated.

Maybe revenue was booked aggressively near year-end.

Maybe there is a disputed invoice.

Maybe the mix changed.

I want the AR aging.

The Aging Report Is Better Than the Balance Sheet

The balance sheet says:

Accounts Receivable: $900,000

The aging might say:

Current: $450,000
31–60 days: $175,000
61–90 days: $100,000
90+ days: $175,000

Now I have a different picture.

Almost 20% of receivables are more than 90 days old.

Are they collectible?

Why are they late?

Is there an allowance for doubtful accounts?

Are any disputed?

A dollar of good receivables is almost a dollar.

A dollar of bad receivables is an accounting souvenir.

I do not want to pay for both at par.

Inventory: Asset or Archaeological Site?

Inventory deserves the same treatment.

The balance sheet might say:

Inventory: $1,000,000

That does not mean I have $1 million of economically useful inventory.

I might have:

$600,000 current saleable stock,
$150,000 slow-moving parts,
$100,000 obsolete product,
$75,000 damaged inventory,
$75,000 items that technically exist somewhere in the warehouse.

This matters enormously in manufacturing and distribution.

A debt-free founder can accumulate inventory for years because it does not hurt him enough to fix the problem.

Then I buy the business with acquisition debt.

Suddenly every unnecessary dollar sitting on a shelf has an opportunity cost.

As I wrote in the net working capital article:

Inventory that has not moved in four years is not working capital. It is a storage hobby.

The balance sheet gives me the inventory value.

The aging report tells me whether I believe it.

Accounts Payable: Free Financing Until It Isn’t

Accounts payable is the other side.

Suppliers have delivered goods or services.

The company has not paid yet.

That is normal.

Trade credit is part of the operating cycle.

But I want to understand whether AP is normal or whether the company is using suppliers as an emergency bank.

Suppose sales are flat.

Accounts payable rises:

$400,000 → $750,000

Cash looks better.

Why?

Perhaps the company negotiated improved terms.

Excellent.

Or perhaps it simply stopped paying suppliers on time.

Less excellent.

The cash flow statement may show positive operating cash because payables increased.

That does not mean the underlying business suddenly became more cash generative.

It may mean the cheque has not gone out yet.

Working Capital Is Where the Income Statement Meets the Balance Sheet

This is why net working capital deserves its own acquisition article.

A company can report excellent EBITDA and consume cash because:

receivables rise,
inventory rises,
payables fall.

The economic definition I use is:

The buyer’s capital temporarily trapped between paying for the work and getting paid for the sale.

If a $5 million company needs $1 million of normalized working capital to operate, that $1 million is part of the economic machine.

It may not be part of enterprise value in the same way as goodwill, but someone has to fund it.

This is why the balance sheet can change what I am willing to pay for the earnings.

Fixed Assets: Book Value Is Not Market Value

Suppose the balance sheet shows:

Property and equipment, net: $1.4 million

What is it worth?

I have no idea yet.

Accounting depreciation is not an appraisal.

A machine bought for $500,000 eight years ago may be almost fully depreciated and still worth $250,000.

Another machine with $300,000 book value may be technologically obsolete and worth $40,000 at auction.

The balance sheet gives me historical accounting information.

For an acquisition I care about at least three different values:

Book value
Market or liquidation value
Productive value to the business

Those can be radically different.

A specialized machine may have poor resale value but be essential to producing $200,000 of annual gross profit.

That machine is economically valuable to me even if the auction market disagrees.

Depreciation Is Non-Cash. Equipment Replacement Is Very Cash.

This is one of the most dangerous ways to misunderstand an asset-heavy business.

EBITDA adds depreciation back because depreciation is a non-cash accounting expense in the current period.

Fine.

But machinery wears out.

Trucks rust.

Forklifts die.

Computers become obsolete.

Buildings need roofs.

Suppose:

EBITDA: $700,000
depreciation: $250,000
actual sustainable maintenance capex: $200,000

I do not have a $700,000 cash machine.

Some meaningful portion of that EBITDA must continually be reinvested just to preserve current earnings.

The financial statements help me estimate this by comparing:

depreciation,
capital expenditures,
gross fixed assets,
accumulated depreciation,
equipment age,
repair expense.

Then I go look at the equipment.

Accounting should eventually meet reality.

A Strange Capex Pattern Is a Question

Imagine:

Year	Depreciation	Capex
2022	$180K	$210K
2023	$190K	$195K
2024	$200K	$185K
2025	$210K	$70K
2026	$220K	$35K

The company is for sale in 2026.

Interesting.

Perhaps management finished a major investment cycle.

Or perhaps the owner stopped buying equipment two years before selling.

If the second explanation is true, EBITDA and cash flow near the sale date may look unusually good because the next owner is about to write the cheques.

Deferred capex is not necessarily on the liability side of the balance sheet.

Economically, it can still be my liability.

Debt: Understand What Exists and What Disappears

The balance sheet may contain:

operating line,
term loans,
equipment loans,
mortgages,
finance leases,
shareholder loans.

In a cash-free, debt-free transaction, some debt may be repaid by the seller at closing.

Other obligations may remain with the company.

Leases may continue.

An operating line may be replaced.

This is also where asset purchase vs share purchase becomes important.

If I buy shares, I buy the corporation itself, subject to the purchase agreement and adjustments.

Historical liabilities matter much more directly.

If I buy selected assets, the liability perimeter can be different.

The balance sheet is not the purchase agreement.

But it tells me where to start asking.

Shareholder Loans Can Tell a Story

Private companies often have amounts due to or from shareholders.

I pay attention.

If the company owes the shareholder $500,000, perhaps the owner previously advanced money to the business.

Why?

Was it startup capital?

A temporary expansion?

A recurring cash shortage?

If the shareholder owes the company $500,000, perhaps the owner withdrew corporate cash in a form that remains on the balance sheet.

Again: why?

Neither is automatically bad.

But related-party balances tell me how the owner and company have financed each other.

That can reveal behaviour I will not see in EBITDA.

Retained Earnings Are Not a Pile of Cash

This is a common conceptual trap.

Suppose the balance sheet shows:

Retained earnings: $2.5 million

That does not mean there is $2.5 million in the bank.

Retained earnings are cumulative accounting earnings retained after dividends or distributions, not a segregated cash account.

The money may have become:

inventory,
equipment,
receivables,
debt repayment,
cash,
some combination.

Profit has to go somewhere.

The balance sheet tells me where it went.

The Cash Flow Statement: Where Did the Money Actually Go?

If the income statement is the most intuitive statement, the cash flow statement may be the most useful.

The cash flow statement separates cash movement into three broad categories:

operating,
investing,
financing.

That separation is incredibly useful for an acquisition buyer.

It tells me whether the company:

generated cash from operations,
reinvested it in assets,
borrowed money or returned money to owners.

This is where reported profitability meets the bank account.

A Profitable Business Can Consume Cash

Suppose:

Net income: $300,000

Sounds good.

Then:

AR increases by $200,000
inventory increases by $150,000
AP increases by $50,000

Net working-capital use of cash:

$300,000

Before capex, essentially the entire accounting profit is trapped in working capital.

Then the company buys:

$150,000 of equipment

Now the company can report $300,000 of profit while cash falls by roughly $150,000 before financing effects.

Nothing fraudulent happened.

The business simply required more cash than the income statement revealed.

This is why I never want to hear:

The company makes $500,000.

Without asking:

In what sense?

Free Cash Flow Is Closer to What Pays Me

There are multiple definitions of free cash flow, but the concept is what matters.

For acquisition analysis, I think roughly in terms of:

Normalized EBITDA
– cash taxes
– maintenance capex
– recurring working-capital investment
= cash available before acquisition debt service

Then:

– principal and interest
= cash remaining for me, growth, reserves and additional debt reduction

That is much closer to the economics I care about.

It also connects directly to how much debt a small business acquisition can actually support.

EBITDA helps value the company.

Cash flow helps keep it alive.

The Three Statements Should Reconcile Into One Story

This is probably the biggest lesson.

I do not want to read three statements.

I want to read one business through three lenses.

Suppose the income statement says:

revenue up 15%,
EBITDA up 20%.

Excellent.

The balance sheet says:

AR up 35%,
inventory up 40%,
AP up 30%.

Interesting.

The cash flow statement says:

operating cash flow down,
capex deferred,
operating line increased.

Now I have a story.

The company is growing profitably on paper, but growth is consuming working capital, suppliers are financing part of it, capital spending has slowed and the bank is funding the rest.

That does not mean I walk away.

It means I stop saying:

EBITDA grew 20%.

And start saying:

What capital will I need to keep this growth going after closing?

That is acquisition analysis.

I Want the Notes Too

The notes can explain:

accounting basis,
depreciation methods,
debt terms,
related-party transactions,
commitments,
contingencies,
asset details,
leases,
concentrations.

The headline statements are the map.

The notes are the legend.

If there is a line I do not understand, I do not skip it because it looks accountant-ish.

I ask.

Compilation, Review or Audit?

Not all financial statements carry the same level of independent assurance.

A small private company may provide accountant-prepared compiled financial information rather than reviewed or audited statements.

That does not make the company bad.

It is normal in much of the small-business market.

But I care enormously about what level of work was actually performed.

I would ask:

Who prepared these?
What engagement was performed?
Were records independently tested?
Are there review or audit statements?
Are there internally prepared monthly statements too?
Do the tax returns agree?
Do bank statements agree?
Does the trial balance agree?

The weaker the assurance attached to the statements, the more corroboration I want elsewhere.

The Tax Return Is a Useful Lie Detector

If the CIM says EBITDA is:

$650,000

and the accountant-prepared statements support it, good.

Then I want the corporate tax returns.

Do they broadly reconcile?

If the seller has spent years telling CRA the company earns very little and now tells me it earns a fortune, we have an awkward conversation.

There can be legitimate accounting and tax differences.

I am not expecting every line to match.

I am expecting someone to explain the bridge.

The general principle is simple:

Does the story make sense?

That might be the best financial due-diligence question there is.

Monthly Statements Can Reveal What Annual Statements Hide

Annual statements smooth things.

I want monthly results if available.

A company that reports:

$600,000 annual EBITDA

might actually produce:

$100,000 per month from March through August,
losses during the rest of the year.

That matters for working capital and debt service.

Or perhaps December contains 40% of annual profit.

Or perhaps profitability collapsed during the last six months but the full-year number still looks acceptable.

I am buying the company now.

The most recent twelve months may matter more than a fiscal year that ended ten months ago.

The Trial Balance Is Where Things Get Less Polished

The financial statements summarize.

The trial balance gets closer to the underlying accounting records.

During serious diligence, my accountant may want:

trial balances,
general ledger,
bank statements,
tax returns,
invoices,
payroll detail,
AR/AP aging,
inventory reports.

A beautifully formatted year-end statement can hide a lot of messy operating detail.

The acquisition is in the detail.

Look for Changes in Accounting Classification

Suppose repairs and maintenance historically ran:

$150,000 a year

Then in the year before sale:

$60,000

EBITDA improves by $90,000.

Wonderful.

Why?

Maybe equipment became more reliable.

Maybe maintenance contracts changed.

Maybe some costs were capitalized rather than expensed.

Maybe repairs were delayed.

Maybe expenses moved to another line.

I am less interested in whether the accounting treatment is technically permitted than in whether the economics changed.

If the business still consumes $150,000 a year keeping equipment alive, moving $90,000 somewhere else does not make me richer.

Watch for Capitalized Expenses

Capitalization can make current-period profit look better because an expenditure goes onto the balance sheet rather than flowing entirely through the income statement immediately.

Sometimes that is exactly correct.

Buying a machine should not generally look the same as buying printer paper.

But if a company suddenly starts capitalizing costs that were historically expensed, I want to understand the policy.

The income statement may improve while cash flow does not.

Again, the three statements expose each other.

Related-Party Expenses Need Normalization in Both Directions

Suppose the seller owns the building personally and charges the company:

$80,000 rent

Market rent is:

$140,000

The business’s reported earnings are overstated for me if I need to pay market rent.

Or perhaps the seller charges:

$200,000

and market rent is $140,000.

Then earnings may be understated.

The same applies to:

family salaries,
management fees,
related companies,
vehicles,
insurance,
shared employees.

Normalization is not a game where every adjustment increases EBITDA.

Sometimes diligence makes earnings go down.

Those are usually the adjustments I trust most.

Look at What the Owner Actually Took Out

A business can report:

$500,000 SDE

But what did the owner actually extract?

I might look at:

salary,
dividends,
shareholder advances,
personal expenses,
management fees,
related-party rent.

That helps me understand the economic benefit the seller received.

It also helps test the advertised earnings.

If the seller claims $600,000 of discretionary cash flow but has never been able to take more than $250,000 out without borrowing, I want to know why.

Perhaps he reinvested heavily.

Perhaps growth consumed cash.

Perhaps the SDE is aggressive.

One-Year Working Capital Can Be Misleading

Year-end balance sheets are snapshots.

A seasonal business can look very different depending on the date.

Suppose a distributor has:

$500,000 NWC at December 31

But normal monthly NWC ranges:

$500,000 to $1.4 million

If I set the acquisition’s working-capital peg from one year-end number, I may badly misunderstand the cash required to operate.

For acquisition purposes, I want monthly balance-sheet data where possible.

I want to understand the operating cycle.

That is why normalized NWC is not just:

Current assets minus current liabilities on the latest statement.

The formula is easy.

The definition and normalization are the negotiation.

Financial Ratios Are Useful After I Understand the Business

I like ratios.

I do not want to start with them.

Useful acquisition ratios include:

gross margin,
EBITDA margin,
current ratio,
debt-to-equity,
interest coverage,
receivables turnover,
average collection period,
days payable,
inventory turnover.

But a ratio without context can mislead.

A current ratio of 2.0 sounds healthy.

Unless half the current assets are obsolete inventory.

A low inventory turnover sounds bad.

Unless the company intentionally stocks critical spare parts with ten-year service lives and extraordinary margins.

A long receivable period sounds bad.

Unless the company’s blue-chip customers contractually pay in 90 days and have essentially no credit risk.

Ratios tell me where to look.

They do not relieve me of looking.

A Simple Acquisition Ratio Dashboard

For a first pass, I would probably track something like:

Metric	What I’m Looking For
Revenue growth	Direction and volatility
Gross margin	Pricing power / mix
EBITDA margin	Operating efficiency
AR days	Collection quality
Inventory turnover	Capital efficiency / obsolescence
AP days	Supplier financing / stress
NWC as % of sales	Capital required to operate
Maintenance capex / EBITDA	Cash conversion
Debt / EBITDA	Existing leverage
Free cash flow / EBITDA	Quality of earnings

Then I compare across years.

The trend is often more useful than the absolute number.

What Makes Me Nervous?

No single item automatically kills a deal.

But combinations matter.

Revenue Up, Receivables Up Much Faster

Potential collection or revenue-quality problem.

Revenue Flat, Inventory Rising

Potential obsolescence, purchasing problem or demand slowdown.

EBITDA Up, Capex Collapsing

Potential deferred investment.

EBITDA Up, Gross Margin Down

Overhead cuts may be temporarily masking deteriorating core economics.

Cash Up, Payables Up Dramatically

Supplier stretching may be creating the cash.

Strong Profit, Constant New Shareholder Loans

Why does a profitable company continually need owner cash?

Large SDE, Weak Owner Withdrawals

Why does advertised cash flow not seem to reach the owner?

Old Equipment, Low Repair Expense, Low Capex

Something may be waiting for me.

Large Related-Party Transactions

Normalization may materially change earnings.

Financial Statements That Arrive Slowly

This one is less mathematical.

If I am buying a company for several million dollars and it takes the seller six weeks to produce last quarter’s income statement, I have learned something about the financial-management system I am buying.

That does not necessarily kill the deal.

It may be an opportunity.

But I am buying the accounting function too.

What Makes Me More Comfortable?

The opposite patterns are attractive.

I like seeing:

several years of clean statements,
monthly reporting,
stable accounting policies,
tax returns that reconcile,
AR aging that makes sense,
low bad debts,
inventory records tied to physical counts,
predictable gross margins,
sensible capex,
clear related-party transactions,
manageable working capital,
cash conversion that resembles reported earnings.

Most importantly, I like when the seller can explain the numbers without performing interpretive dance.

A good owner does not have to be a CPA.

But someone in the company should know why gross margin fell three points last year.

The $500,000 EBITDA Company That Isn’t

Let’s put the statements together.

A business is offered at:

$2 million

Advertised normalized EBITDA:

$500,000

Multiple:

4×

At first glance, reasonable.

Income Statement

Revenue:

$5 million

Reported EBITDA:

$420,000

Seller add-backs:

owner vehicle: $20,000
one-time legal fees: $25,000
excess owner salary: $35,000

Advertised normalized EBITDA:

$500,000

So far, plausible.

Then I Read the Balance Sheet

Accounts receivable:

$1 million

Last year:

$650,000

Inventory:

$1.2 million

Last year:

$900,000

Accounts payable:

$500,000

Last year:

$450,000

Net working capital has expanded dramatically.

I ask for the aging.

AR contains:

$150,000 over 90 days

Inventory contains:

$200,000 that has not moved in two years

Now the balance sheet is telling me that some of the assets supporting the purchase-price discussion are lower quality than they looked.

Then I Look at Fixed Assets

Depreciation:

$180,000

Capex:

three-year average: $170,000
last year: $45,000

The seller says:

We didn’t need much last year.

Maybe.

During the plant tour I find two machines likely to need replacement within three years.

Estimated cost:

$450,000

Now I am thinking about sustainable maintenance capex very differently.

Then the Cash Flow Statement

EBITDA looks good.

But:

receivables consumed cash,
inventory consumed cash,
capex was temporarily low,
the operating line increased.

The business did not throw off anything close to $500,000 of cash.

Then I Normalize the Normalization

The owner’s $35,000 salary add-back assumes I can replace his work for less than he was paid.

I cannot.

He handles key accounts and operations.

Market replacement cost is actually:

$75,000 more than the salary remaining in the P&L after his proposed adjustment.

My normalized EBITDA falls:

$500,000 → $425,000

Then I recognize sustainable maintenance capex is probably:

$150,000–$180,000

And the company needs substantial working capital.

Did the seller lie?

Not necessarily.

Is the business bad?

Not necessarily.

Is it a $2 million business at four times $500,000?

Not to me.

That is what reading the financial statements is supposed to accomplish.

The Reverse Can Happen Too

Diligence is not only about finding reasons to lower the price.

Suppose a business reports:

$350,000 EBITDA

But I discover:

owner pays above-market related-party rent: $75,000 excess,
spouse receives $60,000 but does little work,
$50,000 legal expense was genuinely one-time,
equipment was heavily renewed over the past three years,
inventory is clean,
AR collections are excellent,
NWC is efficient.

Normalized EBITDA may be closer to:

$500,000

and the balance sheet may be healthier than the income statement initially suggested.

That can be a much better acquisition than the prettier CIM.

Financial diligence should change my view in either direction.

If every adjustment I make improves the seller’s number, I am probably negotiating with myself.

Quality of Earnings Is the Next Level

For a material acquisition, I would strongly consider a proper quality-of-earnings analysis depending on the size and complexity of the deal.

A quality-of-earnings report is a deeper third-party analysis of the accuracy and sustainability of historical earnings.

It can help test:

revenue quality,
EBITDA adjustments,
working capital,
accounting consistency,
customer trends,
sustainability of margins.

I still want to understand the financials myself.

Professional diligence does not replace buyer understanding.

It tests it.

I Want My Accountant to Disagree With Me

If I become excited about a business, I am dangerous.

I can explain things.

Revenue decline?

Temporary.

Customer concentration?

Long relationship.

Old machines?

Well maintained.

Seller dependence?

Transition agreement.

Rising inventory?

Growth.

This is exactly why I want independent advisors.

I want an accountant who is willing to tell me:

Andrew, you’re rationalizing this.

That is a feature.

But I Still Need to Own the Model

The accountant can help determine whether EBITDA is real.

The lawyer can protect the transaction.

The lender can size debt.

The broker can explain the seller’s expectations.

None of them has to own the company afterward.

I do.

So I want my own simple acquisition model.

At minimum:

Earnings

revenue,
gross profit,
normalized EBITDA,
owner replacement cost.

Capital

normalized NWC,
maintenance capex,
immediate capex needs.

Cash Flow

cash taxes,
normalized free cash flow,
acquisition debt service.

Risk

customer concentration,
owner dependence,
revenue volatility,
margin sensitivity.

Then I can connect the financial statements to the purchase price.

The Statements Should Change the Valuation

This is where financial-statement analysis stops being academic.

Suppose I initially value a company at:

4.5× $500,000 EBITDA = $2.25 million

Diligence shows:

true normalized EBITDA: $450,000,
$150,000 excess or obsolete inventory,
$300,000 near-term capex requirement,
NWC requirement $200,000 higher than expected.

I do not simply say:

Interesting accounting findings.

Those findings belong in:

price,
NWC peg,
seller financing,
representations and warranties,
holdbacks,
financing structure,
or my decision to walk away.

The point of diligence is not to produce a beautiful binder.

It is to change the deal when the facts change.

Financial Statements Also Tell Me What I Can Improve

This is the part I enjoy.

I am not only looking for danger.

I am looking for opportunity.

Suppose I find:

AR days: 68 instead of roughly 45,
$300,000 excess inventory,
gross margin two points below historical levels,
weak purchasing discipline,
no monthly management reporting.

Those can be problems.

They can also be the acquisition thesis.

If I reduce AR by $250,000 and inventory by $300,000, I may release:

$550,000 of cash

without increasing sales by one dollar.

If I restore two points of gross margin on $5 million revenue:

$100,000 additional gross profit

If that flows largely to EBITDA and the company is worth 4.5× earnings, the operational improvement could create roughly:

$450,000 of enterprise value

Now the statements are not just telling me what the company was.

They are showing me what it might become.

This Is Why I Like Messy but Understandable Businesses

A perfectly optimized company deserves a premium.

It may also leave me with less to do.

I am interested in a different category:

A good underlying business with fixable financial inefficiency.

Maybe:

too much working capital,
weak pricing,
poor reporting,
owner-dependent sales,
excess expenses,
underused equipment,
no disciplined budgeting.

I do not want accounting chaos that prevents me from knowing whether the earnings exist.

But operational mess with understandable economics can be interesting.

The financial statements help distinguish one from the other.

The Business I Want Has Two Returns

When I buy a company, I am looking for two sources of return.

Return #1: The Business I Bought

Existing normalized free cash flow.

If nothing improves, does the acquisition still make sense?

Return #2: The Business I Can Build

Margin improvement.

Growth.

Working-capital efficiency.

Management depth.

Debt paydown.

Multiple improvement.

I do not want Return #2 to be required to rescue a bad Return #1.

But I absolutely want to see it.

The financial statements give me the baseline for both.

My Financial Statement Diligence List

If I were reviewing a serious acquisition today, I would want at least:

Three to five years of accountant-prepared annual financial statements.
Current year-to-date statements.
Comparable prior-year interim statements.
Monthly income statements and balance sheets if available.
Corporate tax returns.
Trial balances.
General ledger detail where required.
Bank statements.
AR aging.
AP aging.
Inventory aging and inventory-detail reports.
Revenue by customer.
Revenue and gross margin by product or service line.
Fixed-asset register.
Capex history.
Debt schedules.
Lease obligations.
Shareholder and related-party accounts.
Payroll detail.
Budgets and forecasts.

Then I would try to reconcile everything into a handful of conclusions.

The Questions I Want Answered Before Closing

Income Statement

What is sustainable revenue?
What is sustainable gross margin?
What expenses disappear?
What expenses appear under me?
What is buyer-normalized EBITDA?

Balance Sheet

Are receivables collectible?
Is inventory saleable?
What NWC does the company really require?
What assets need replacing?
What liabilities exist?
What related-party balances need to be resolved?

Cash Flow

How much EBITDA becomes cash?
What does maintenance capex consume?
What does growth consume?
Can the business service acquisition debt?
How much cash is left after it does?

Overall

Do the three statements tell the same story?
Does the seller’s story agree with them?
Does the purchase price still make sense?

That is enough to get me a long way.

The Numbers Are Not the Business

There is an important limit to all of this.

A set of financial statements will not tell me:

whether the plant manager is leaving,
whether the largest customer hates the seller,
whether a competitor just launched a better product,
whether the company has a great culture,
whether the sales pipeline is real,
whether the owner works seventy hours a week,
whether a machine sounds like it is about to throw a connecting rod through the wall.

Financial statements are evidence.

They are not reality.

I need commercial, operational, legal and employee diligence too.

But financial statements give me something extraordinarily useful.

They give me a structured way to challenge the story I want to believe.

What the Numbers Are Actually Telling Me

When I first started looking seriously at business acquisitions, I naturally gravitated to the income statement.

Revenue.

EBITDA.

Multiple.

That is where the listing starts.

The deeper I get into acquisitions, the more time I spend moving sideways.

From EBITDA to receivables.

From receivables to cash flow.

From cash flow to inventory.

From inventory to working capital.

From depreciation to capex.

From owner compensation to replacement salary.

From debt to debt service.

The business is not one number.

It is a machine that converts capital, labour and customer relationships into cash.

The financial statements show different parts of that machine.

The income statement tells me how profitable the machine appears.

The balance sheet tells me how much capital is sitting inside it.

The cash flow statement tells me whether money is actually coming out.

And the notes tell me what the accountant thought I needed to know before believing any of the above.

That is why I do not need to become an accountant to buy a business.

I need to become financially literate enough that when my accountant says:

Receivables are deteriorating, inventory is aging and normalized EBITDA is probably $100,000 lower than the CIM says.

I understand exactly why that changes the acquisition.

The goal is not to read financial statements.

The goal is to read the business through the financial statements.

Because I am not buying the statements.

I am buying whatever cash flow is still there after the accounting meets reality.

Sources and Further Reading

Disclaimer: This article is for general informational purposes and documents how I think about evaluating Canadian business acquisitions. It is not accounting, tax, legal, valuation, lending or investment advice. Financial-statement presentation, accounting policies, transaction structures and due-diligence requirements vary materially between businesses. A serious acquisition should be reviewed with qualified accounting, legal, tax and financing professionals experienced in business transactions.