A common challenge when completing a business valuation for SBA 7(a) purposes is how much reliance should be given to the seller’s interim financial statements. Generally, an SBA lender will provide an appraiser with three years of business tax returns and interim financial statements as of the current calendar year.
This is where certain trends may be observed from the interim financial statements on an annualized basis that have large divergences from the business tax returns. Consider a business that has declining revenues in the three historical fiscal years, but the Q1 2024 interim statements show that, on an annualized basis, 2024 will result in an increase to 2023 revenues. The interim statements also display that the company’s profitability has improved.
The value of a business is generally based upon the future cash flows expected to be generated. Therefore, the appraiser’s task is to determine which historical years, if any, represent the most likely future performance of the business as of the valuation date. After this decision is made, the next question is whether the interim financial statements should also be considered. If an appraiser assumed the company’s Q1 2024 performance was sustainable, the valuation of this company would be higher versus using 2023’s results, and all else would be equal. This can also work in the opposite direction, whereas interim statements show that a company is performing worse than it was in the prior year.
This requires the appraiser to learn more about the financial results and the corresponding business story. As always, a complete understanding of the company’s business story is necessary to provide a reliable business valuation. To understand a business’s story, an appraiser will typically ask the parties to a transaction, their representatives, and the lending bank a series of probing questions based on the financials and deal documents provided. The numbers can only tell an appraiser so much.
SBA 7(a) Business Valuation Quote Request
Today’s global environment has elevated the importance of valuations that support financial reporting, tax planning, litigation, mergers and acquisitions and more. Our team prides itself on delivering reliable results, competitive pricing and a quick turnaround time.
Key Considerations When Relying on Interim Financial Statements
The following thoughts summarize what we consider when deciding how much to rely upon interim financial statements when performing an SBA business valuation.
- Skepticism Warranted – Given that interim statements are usually internally prepared, we typically begin from a place of skepticism to rely upon them. This is especially true when comparing profitability (more on this below), where a business may show a dramatic difference in its margins. As business valuation heavily depends on future performance, it is critical to understand if this data is legitimate and repeatable. This is not to say that interims will not be relied upon; rather, there is a lot of work to get comfortable with such reliance.
- Revenue > Profits – It is less likely that a business owner is delaying receiving revenue versus paying an expense. Certain expenses, such as bonuses and other costs, are more likely to be paid at year-end, which would decrease taxable income, especially when electing cash basis accounting. Generally, after completing due diligence, we will be more comfortable assuming interim revenue performance is achievable versus profitability. It is essential also to review the borrower’s forecast and compare it to the results of the interim statements. We want to understand why the annualized revenue does not align with the borrower’s projected revenue. If the company has higher margins in the interim period, we should seek to understand how such cost savings have been achieved. For example, if the company has laid off two workers and has no plans to replace them, margin improvements may be viewed as being more likely to continue. In comparison, if the company actively seeks to replace such employees, the margin improvements may be non-recurring.
- Accrual vs. Cash – Quite often, we receive tax returns on a cash basis and interims on an accrual basis. This creates a problem of comparability for obvious reasons. Always be sure to the extent possible that the interims are on the same accounting basis as the tax returns. One of the most significant issues here is working capital. The business will show little working capital on a cash basis but then have a large amount in the interims on an accrual basis. This does not leave the appraiser much company-specific data to understand the company’s historical working capital needs. If historical accrual statements are unavailable, the appraiser may rely upon industry benchmark data to estimate the company’s working capital requirements.
- Year-over-Year (YoY) Comparison – This will provide a greater understanding of how accurate the previous year’s interims were compared to the company’s full-year business tax return. It will also assist in understanding seasonality (more below) and if it is reasonable to annualize the interim performance of the business. By reviewing the comparative interim statement from the previous year, we can understand if the company could maintain its interim margins and the percentage of revenue earned versus the full-year period.
- Duration Matters – All else equal, an interim income statement for one month is much less reliable than one for ten months. The duration of the income statement should be taken into consideration before the valuation relies upon it.
- Seasonality – Some small businesses are very seasonal. For example, a liquor store will rarely be on track to achieve its previous year’s revenues through June. We should not be alarmed if the annualized revenue through six months is less than the previous full-year revenues. This is because a non-proportional amount of sales occur on July 4th, Thanksgiving, Christmas and New Year’s Eve. Therefore, the only insight one can gain here is to see how the liquor store was performing at this time last June, hence the YoY comparison mentioned above.
Key Takeaways
The reliance on interim financial statements can have a material impact on the business valuation of a company for SBA purposes. The above items should be reviewed and scrutinized prior to relying upon them. In the case of interim statements, numbers can lie, and the ability to gain comfort in relying upon them can only be achieved by understanding the story of the business. If a business valuation has relied upon the interim performance of the business, all the above considerations should be documented. It should be apparent to the reader why such reliance was made or not made by the appraiser.
Contact Us
For more information on this topic, please contact a member of Withum’s SBA Business Valuations Team.
