Annualizing Income Statements

When listing a business the Seller usually provides the business broker with tax returns for prior years and an interim income statement for the current year.  For small businesses such interim statements are often on a cash basis and are often prepared by management.

Annualizing interim statements without reviewing the result for reasonableness may create problems during due diligence when it becomes obvious that annualized revenue and/or earnings were overstated.

It’s not unusual for interim income statements to show higher profitability than year end-tax returns, or year-end financial statements.  There can be several reasons why this occurs, including:

1. Business owners, whose financial statements are prepared on a cash basis, in order to reduce income tax liabilities hold checks received at the end of one year depositing them after the first of the following year.  The result is that the Company’s income and earnings are inflated at the beginning of the year.  Interim statements prepared early in the year are inflated more on a percentage basis than those prepared later in the year.  If the business owner holds the same dollar amount of checks at the end of the current year the year-end income will no longer be inflated.
2. Management-prepared income statements often do not include all expense items.  For example, expenses that are paid by direct-withdrawal from the company’s checking account may not be included in expenses until the firm’s accountant prepares the year-end financial statements.  Interim statements may also include non-operating items under income.  For example, the proceeds from the sale of the owner’s personal luxury automobile or other company assets; or, a cash infusion from the owner may have been included in income rather than being entered on the balance sheet as a loan.  Omission of expense items or inclusion of non-operating income in the subject’s reported revenues inflate the company’s reported profitability.
3. Interim statements may include annual or semi-annual expenses such as insurance premiums.  Annualizing such items will over-state G&A expenses
4. The company’s mix of business and/or discretionary expenses may have been reduced increasing the firm’s profitability.  That is, the reduction in expenses may be real.

When considering annualizing an interim income statement, compare the subject’s cost of goods sold (COGS) and total G&A expenses with year-end values for prior years.  If the interim statements do not include expenses such as depreciation, deduct such expenses from prior year statements before making the comparison.  If the expenses as a percent of revenue in the interim statement are significantly different than in prior years discuss this with the Seller or the company’s accountant to find out why.  Are the differences real, or was income inflated or expenses understated / overstated?  Also ask the Seller if the annualized revenues are in agreement with his/her projections and make sure there aren’t any significant non-operating income items included in interim statement revenues.

Certain expenses may be allocated differently from year to year, i.e., included in COGS in some years and in G&A expenses in other years, therefore it may be necessary to compare total expenses (i.e., COGS plus total G&A expenses) in the interim statements with prior years.

To avoid some of the problems associated with annualizing interim income statements, request an interim statement for the same period for the previous year (remember to check both interim statements for the potential problems discussed above).  Using this information, one can present the income statement for the trailing twelve months (as of the date of the interim statements) rather than annualizing a few months.  For example, if:

2008 Year-End Revenues = $700,000

April 30, 2008 Revenues  = $200,000

April 30, 2009 Revenues  =  $250,000

Trailing 12 months revenue   = 2008 Year-End Revenues – April 30, 2008 Revenues + April 30,   2009 Revenues

= $700,000 – $200,000 + $250,000 = $750,000

TTM expenses can be calculated in the same manner.

Remember, if you overstate current year income / profitability it can come back to haunt you if a contract is executed near the end of the year and due diligence shows that year-end revenues / earnings will be significantly lower than your annualized projections.