Most small-business owners become entrepreneurs by starting a business. When you start a business, you begin with zero income and zero assets, making it difficult to obtain bank financing. Buying a business is another way to become an entrepreneur. Profitable businesses with a track record, cash flow and assets are more attractive to banks. When buying a business, all financial statements are important, but the balance sheet has special significance.
A major consideration for a buyer is the value of the business. The balance sheet provides a base value for the company you are buying and shows what resources you have to work with. Most small-business purchases are asset purchases, meaning that the valuation is largely driven by the balance sheet. This also occurs because many small-business sellers focused on reducing income to decrease their taxes. The resulting low profitability drives down income-based sales prices.
The amount and quality of assets is the most important aspect of the balance sheet for a buyer. The level of cash is key. A lot of cash means that you have cash to use to run the business or, if the seller keeps the cash, you reduce the amount of your own money or loans needed to buy the business. The amount of accounts receivable indicates sales made but not yet paid for by customers.
As long as customers pay on a timely basis, typically 30 days or less, you will quickly convert these receivables to cash. Prepaids, or services paid for in advance including insurance or rent, reduce payouts in the near future. Inventory means there is stock for you to sell. Long-term assets including equipment, computers and furniture, means that you have the assets on hand necessary to operate the business or to sell to generate cash.
You must check the quality of all the assets. Accounts receivable must have low aging, because those that extend well past 60 days are often uncollectible. You cannot sell inventory that is old or in poor condition for its regular price. Long-term assets that are almost fully depreciated are most likely at or near the end of their useful lives, meaning that they will need replacement soon. A detailed balance sheet shows the asset, its accumulated depreciation -- shown under an asset and subtracted from the asset's overall value-- and its net value.
Liabilities are what a company owes its creditors -- obligations or debts that must be fulfilled. In an asset purchase, the buyer lists the specific assets he is purchasing and therefore, the seller retains most of the liabilities. However, the seller may require you to assume and pay the short-term liabilities, including accounts payable and customer deposits.
Book value is important because it provides you with a base valuation for the company. A company's book value is another name for owners equity, which is also referred to as net worth. On the balance sheet, assets equal liabilities plus owners equity or, alternatively, assets plus liabilities equal net worth.