The Ultimate Web Site Valuation Guide

Reconstructing Financial Statements

Balance Sheets (BS), Profit and Loss Statements (P&L, also sometimes called Income Statements), Cash Flow Statements, and so on, are some of the statements that help run a business and comply with the law. You can create your own balance sheet or P&L account using these easy spreadsheets.

We’ll discuss here what these financial statements are, where they are useful, and why the standard statements need to be reconstructed for the purposes of valuing a business.

NOTE: Beware the Terminology Trap

Remember that terminology can differ between countries, between cultures and between professions. For example, in North America the term “revenue” is often used interchangeably with “turnover”, whereas in the UK it means “profit”.

Why redo the financial statements? Earlier, we’ve covered why the Fair Market Value (FMV) of a site differs from its fair market value. To recap, FMV calculated by accountants is done to meet legal formalities and it rarely reflects real fair market value of the type a buyer would pay. Usually—but not always—the FMV is less than the realizable price, as accountants are incentivized to value conservatively.

Other statements that a business prepares, notably the BS and P&L, are prepared to minimize its tax bills while complying with strict legal curbs on how these statements should be prepared. The P&L is meant to show a fair summary of the business’s trading over the year, and the BS is meant to be an accurate reflection of the state of the business’s finances on a specific day.

These statements impact considerably on a business. The figures that appear in them end up contributing to credit score and determining the interest rate the business pays on its overdraft. These statements are submitted to the tax authorities and are core documents in the calculation of tax liability. Governments also use these final accounts to compile national statistics that affect the formation of further policies and taxes. And the other business influences they exert are too numerous to mention.

Businesses are motivated, therefore, to tailor these statements to their convenience. They may look for ways to show higher expenses (therefore lower taxable profits) or to boost the values of fixed assets on the BS (thus improving their credit scores). They’ve got to keep any such doctoring within strict rules governing these matters, but a good accountant can save a business millions in tax just by controlling how this information is presented.

Not all financial statements come from a business’s annual accounts. Sometimes they’ve been put together for other reasons, such as:

• probate
• insurance valuations or claims
• asset protection (pre-empting a threat such as divorce)

Whatever the original purpose behind the statements, the business buyer has to see through those adjustments made purely for tax or other purposes and come to his or her own conclusions as to what the state of the business is (BS) and how it fared over the year (P&L). To do that, it’s necessary to reconstruct those financial statements upon which to base a decision.

Governments may also offer various tax breaks, such as tax incentives for investment in IT, deferred tax for infrastructure costs, or reduced tax for research and development expenditure.

Let’s take as an example a company with $20,000 in sales, and the following Profit and Loss statement:

Let’s say the business is based in a country with a 20% corporation tax rate. Based on the information so far, its tax liability is, of course, $2,000.

The business’s accountant points out that it can save some tax if its IT equipment is depreciated by the full allowed 25% (the current value of the equipment is $8,000). She also points out that the government is giving small businesses a tax break if based in an area of high unemployment, so this company is eligible for a flat allowance of $4,000. The company also invested in some research and development over the year, and is eligible to reduce taxable profits by a further amount of $4,000.

That takes the company’s taxable income to $0—and makes the owner of the company very happy.

During the course of the subsequent year, however, he decides to sell. The prospective buyers’ first impressions are of a company that makes no profit at all. But, on delving into the figures, they realize that they need to add back those deductions that were made for tax reasons, and they need to add back some of those original expenses to arrive at the true profit the business made last year.

But it’s not always that the reconstructed figure shows a higher profit. The prospective buyer may apply his or her own valuations to the assets and apply a larger depreciation for depleted assets that need to be replaced, or deduct a notional salary for the owner’s time that wasn’t accounted for earlier ... and so on.

In conclusion, for low-value businesses, it’s hardly worth anybody’s time to redo the statements; however, no large business is sold without this recalculation done by the buyers’ due diligence team. No smart buyer would completely trust the seller’s accountant’s figures. And if there is a bank loan involved in the purchase, such reconstruction would be a prerequisite, a sine qua non.

Most web sites sold in the popular site-selling forums fall below the level where it’s economic to appoint expensive advisors to reconstruct financial statements. In fact, many of these sites for sale don’t have formal financial statements.

Where there is a statement of sorts, it tends to be more along the lines of a proft and loss statement, which demonstrates cash inflows (earnings) and outflows (expenses) over the course of the year. There is hardly ever a formal Balance Sheet unless the business had been preparing formal accounts.

The Income Statement presented is usually of a less than professional standard and almost never matches national and international accountancy conventions. Buyers, nevertheless, either plug the figures into their own spreadsheets to do a quick-and-dirty reconstruction ... or do the reconstruction mentally if it’s a fairly simple business model without too many elements to consider. The most common deduction prospective buyers make from stated income is probably a nominal (notional) salary—an expense often overlooked by site sellers.