Four Years of Financials, Two Opposite Pressures

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A target’s four years of financials may not be four years of the same thing. The older returns may have been built to hold taxes down, and the recent ones to hold a valuation up, and the real number may sit between them.

When a buyer hands me a target’s financials and asks what I think, the first thing I tell them is that they may not be looking at four years of the same thing. They may be looking at a few years of numbers built to hold taxes down, followed by a year or two of numbers built to hold a valuation up, and the two are pulling in opposite directions on the same page. Reading a target’s earnings well starts with knowing which force was at work in each year and correcting for both.

Here is where I actually start. I want the last three years of filed tax returns and the current-year interim statements in front of me at the same time. I am not looking at add-backs yet. I am looking at the shape of the business over four years, top-line revenue, cost of goods sold, and what fell to the bottom line each year. Before I care about any single adjustment, I want to know the trend and see whether any year is an outlier. Then I go down the income statement line by line and look for the categories that jump, a cost that is high one year and normal the next three, a margin that moves in a way the revenue does not explain, a line that behaves differently in the most recent year than it did in the three before it. The outliers are where the story is, and they are what I chase first.

Then I factor in what most buyers don’t think about: the motivation behind the numbers changed partway through the period I am looking at.

Go back three and four years and you are almost always looking at tax-motivated financials. The owner, like most owners, prepared those returns with their accountant trying to keep taxable income down, because every dollar of reported profit was a dollar they paid tax on, and they had no reason yet to do anything else. That means those older years often understate the business’s real earning power. Aggressive expensing, owner perks run through the company, family on the payroll, equipment written off fast, a conservative revenue posture. I am not indicating that any of it is improper, and it all pushes the reported bottom line below what the business actually earns. When you normalize those years honestly, the adjustments generally run upward, and that helps the seller’s value case rather than hurting it.

The recent year, and often the current interim period, is a different animal, because by then the motivation has usually flipped. Somewhere in there the owner started thinking about a sale, and a business broker or an investment banker told them what every good advisor tells a seller: that they need to clean up the books, tighten the expenses, and present the strongest defensible bottom line they can, because that is what positions the company for the value they are hoping to get. That is legitimate. It is exactly what a seller should do, and it is what I would coach a seller to do myself. But it means the most recent numbers are built to hold a valuation up, and in my experience that sale-motivated pressure is the stronger of the two forces, so the recent year is the one where the bottom line is most likely to be flattering rather than representative.

So I get more skeptical, not less, as the numbers get newer. That runs against a buyer’s instinct, because the recent year feels like the most relevant one and the older years feel like history. But the recent year is the one somebody was actively managing toward a number, and it is the one most likely to include expenses that got reclassified or deferred, discretionary spending that quietly disappeared the year before going to market, and revenue that was pushed as hard as it could be pushed. I am not assuming any of that happened. I am assuming it might have, and I read the recent year as something to be corroborated rather than taken at face value.

If a broker, banker, or CPA firm has already provided a set of normalization and owner-benefit adjustments, I read those closely, and I read them as a starting position rather than an answer. Some of the adjustments will be clearly right: the owner’s above-market salary, a genuine one-time legal expense, a personal vehicle, rent adjusted to market rates. Others will be aggressive: an add-back for something that is going to recur no matter who owns the business, a one-time item that is not really one-time, a normalization that assumes a level of performance the company has not actually demonstrated. The adjustments are an argument the sell side is making about what the business really earns, and my job is to test that argument against four years of evidence, not to accept it or dismiss it wholesale.

What I am doing through all of this is triangulating toward the real number, which usually sits somewhere between the tax-motivated floor of the older years and the sale-motivated ceiling of the recent ones. The older returns tell me what the business was willing to admit it earned when the goal was paying less tax. The recent numbers tell me what the seller wants to prove it earns now that the goal is a sale. The truth is generally in between, and finding it is most of what earnings review actually is. It is less about catching a seller doing something wrong than about correcting for two honest and opposite biases, so a buyer can pay a price based on what the company actually produces rather than on whichever year’s version of the story is most convenient.

None of this replaces a quality of earnings report, and on any deal of real size a lender is going to require one, performed independently. But a formal QoE comes later, after there is a deal to underwrite. The reading I am describing happens first, at the buyer’s own desk, on the buyer’s own time, and it is what tells a buyer whether a business is worth pursuing to the point of ordering that report at all. A buyer who can read four years of statements and see the two opposing forces at work is a buyer who knows what they are looking at before they spend a dollar proving it.

A note for the CPAs who refer clients to me

This installment is closest to your own daily work, and it is where a buyer benefits most from having their CPA in the room alongside me. When a client of yours is looking at a target, you are the person best equipped to read those tax returns the way they were actually prepared, because you prepare returns like them, and you know what tax-motivated financials look like from the inside. The reading I describe here, separating the older understated years from the recent positioned ones, is a natural collaboration between the buyer’s advisor and the buyer’s accountant, and a client is far better served when the two of us are working the same statements from our respective angles rather than one of us working them alone. If you have a client evaluating an acquisition, this is exactly the point where bringing me in adds to what you already do rather than duplicating it.

A note for the wealth advisors

The earnings review is where a buyer finds out whether the business they are excited about actually produces what the marketing says it does, and that matters to you because your client is often about to move a meaningful share of their net worth into this one asset. A client who overpays because they took a dressed-up recent year at face value has done real and lasting damage to the financial plan you have built with them, and it is the kind of damage that does not show up until years later. When a client of yours is heading toward an acquisition, the diligence on the target’s earnings is not separate from their financial plan, it is part of protecting it, and it is worth making sure the person reviewing those numbers is doing the both-directions reading rather than simply accepting the seller’s adjustments. Being in the conversation while that work is happening keeps you close to a decision that will shape the client’s balance sheet for a long time.