08 Oct Do You Know What Your Business’s Financials Are Telling You?
Carlos recently sat down with a business owner to review an SDE analysis. Seller’s Discretionary Earnings, or SDE, is a measure commonly used to estimate the financial benefit a business provides to one working owner. For many small businesses, it is also one of the starting points for determining what a buyer might reasonably pay.
The owner had never seen his financial results presented that way. As the conversation continued, it became apparent that he had never routinely compared one year with another, monitored his gross margins, or considered how changes in cost of goods sold were affecting profitability. In fact, he had paid very little attention to the company’s financial statements at all.
He had placed his trust in his bookkeeper. But because he did not understand the basic financial measures himself, he also had no way to evaluate whether the information he was receiving was complete, accurate, or useful.
That does not mean he was inattentive to his business. Far from it. Like many owners, he understood it through the work itself: customers, employees, sales, daily problems, and the balance in the bank account. What he lacked was a financial framework for understanding what all that activity was producing.
Financial Statements Should Be More Than Tax-Time Paperwork
Many small-business owners rely heavily on a bookkeeper or accountant, and appropriately so. Owners have businesses to run and cannot be expected to become experts in every aspect of accounting.
But bookkeeping and financial oversight are not quite the same thing.
A bookkeeper may accurately record income and expenses, reconcile accounts, and prepare reports. An accountant may prepare a tax return based on that information. Neither relationship necessarily ensures that someone is helping the owner interpret what the numbers say about the company’s performance.
A business can remain busy while becoming less profitable. Revenue can increase while margins contract. Rising material, labor, or inventory costs can quietly absorb the benefit of higher sales. If the owner looks primarily at revenue or the current bank balance, those changes may go unnoticed.
Cost of goods sold is a good example. COGS generally includes the direct costs associated with producing the goods or services a company sells. When those costs rise but prices do not keep pace, gross margins decline. The company may be doing more work without producing more income for the owner.
That is not an abstract accounting issue. It can affect the owner’s compensation, the company’s ability to hire or invest, its borrowing capacity, and ultimately its value to a buyer.
You Don’t Need to Become an Accountant
An owner does not need to master every account on the general ledger. A relatively small set of questions can reveal a great deal:
- Is revenue increasing, declining, or remaining flat?
- Are gross margins changing?
- Are operating expenses growing faster than sales?
- Which products, services, or locations are producing the strongest results?
- How does this year compare with last year?
- How much income does the business actually provide to its owner?
- Are the financial statements consistent with what appears to be happening operationally?
The goal is not to second-guess every bookkeeping entry. It is to understand enough to ask useful questions and recognize when the results do not make sense.
Trusting a bookkeeper or accountant remains important. But trust works best when the owner has enough familiarity with the numbers to participate in the conversation. Otherwise, the company’s financial performance can become something the owner learns about only when applying for a loan, responding to a buyer, or preparing to sell.
Seeing the Business More Clearly
When Sam Goldenberg & Associates prepares an SDE analysis, the immediate purpose may be to estimate the business’s likely market value. But the process often reveals something more fundamental.
For some owners, it is the first time several years of financial performance have been laid out side by side. Trends become visible. Questions that never occurred to anyone begin to surface. An expense that seemed insignificant may have grown steadily. Revenue may be increasing while the owner’s income remains unchanged. One part of the company may be supporting another without anyone fully realizing it.
These discoveries are easier to address while the owner is still engaged in the business and has time to make changes.
The first value of an SDE analysis is not always learning what the business might sell for. Sometimes it is learning what business you actually own.
