Common red flags in SMB financials: what to watch out for and how to address them

Finding the right business to purchase or invest in means executing a thoughtful and structured due diligence process. 

Whether a company has $1M or $10M in EBITDA, it’s critical to identify and address potential red flags in due diligence and determine how to proceed with the transaction, if at all. 

Below, we discuss some common red flags to be aware of in SMB transactions according to industry professionals, highlight some strategies for finding those flags, and then show you what you can do to manage them.

Red flags to watch out for in SMB financials

Inconsistent earnings

“If a target business’ revenue or EBITDA are cresting and falling rather than steadily inclining, that is definitely something to look into,” says Main Street Securities LLC investment banking representative Wade Bruffey. 

It’s important to note whether the fluctuations are due to broader macroeconomic events (e.g., COVID-19 or rising interest rates) or representative of an underlying issue in the company's operations. A substantial decline in EBITDA margins each year could be symptomatic of a pricing issue, change in products or services, or higher operating expenses. 

Assuming the chart below follows a lawn care company that provides snow removal services in winter, the Q3 2022 EBITDA value could have declined due to consumers preferring to shovel their driveways or snow removal expenses increasing, for instance. Red flags like this are worth investigating further to understand if declining EBITDA numbers present an inherent risk with the business or if it’s due to seasonality which can be underwritten and managed.

Inconsistent earnings on the company’s financials only tell half of the story. Once you understand the context behind the ups and downs of a company’s earnings, you can determine whether they represent an issue.

Accounts receivable aging

Large amounts of unpaid accounts can impact a company’s short-term liquidity and lead to future issues with cash flow management. Companies with a longer cash conversion cycle, or worse, defaulted accounts, present challenges to correcting their collections processes.

Limited financial data

Alex Silensky, partner at OGS Capital, says another common issue in SMB transactions is limited financial data from sellers, which can be the case in smaller businesses that may not generate the quality financial statements buyers need to review. 

“It’s common that sellers who submit these initial reported EBITDA numbers…[most of the time] the numbers will be much lower, so normalized earnings will be much less than the reported EBITDA,” he explained.

Heavy family involvement 

While family involvement in small businesses is fairly common, acquiring a business like this can introduce additional risks of key-person departure or conflicting expectations among family employees.

It’s important to understand each family member’s role in the business and their plans post-acquisition to determine who you’ll need to replace or transition within the organization after the deal closes. 

Customer concentration

A business with a significant portion of its revenue from one client or project has a high amount of financial risk. Using the landscaping company as an example, ABC Corp. has a contract with a local hospital that brings in 30% of its annual revenue. If this contract or client fell through, this could mean missing upcoming expense payments that were accounted for earlier in the year when forecasting earnings—which assumed that the client was not at risk of being lost. 

Customer concentration and customer relationships often go hand in hand. The better the relationship—and contract—with a larger client, the less of a flight risk they are.

Maintenance CapEx

Maintenance CapEx is the cost of sustaining a business’ ongoing revenue and profits by making long-term investments in the maintenance of existing assets. An example would be the ongoing expense of replacing lawn-mower tires, or worn out parts on machinery.

While high maintenance CapEx can lead to lower free cash flow, investments in existing assets is sometimes necessary to ensure you don’t lose current customers.

Entangled real estate 

Business acquisitions which include real estate in the deal value can muddy potential investor returns given the difference in growth assumptions of real estate and businesses. This is because generally real estate appreciates slower than a growing small business opportunity.

As a result, acquirers may have to raise more capital upfront to make up for the real estate value that still caries a significant debt load, which could negative impact potential investor returns. 

How to find red flags through proper due diligence

Quality of earnings reports

A quality of earnings (QoE) report, typically completed by a CPA firm or financial due diligence provider, can reveal possible red flags in a business. While these reports were formerly reserved for large M&A deals, they are increasingly utilized in smaller transactions today. 

A QoE unearths financial risks or discrepancies between a business’ provided financials and the potential changes under a new owner. QoE’s findings are based on a CPA’s review of financial statements, bank statements, and other sources of financial data. 

“Quality of earnings [reports] for a bigger deal, or a deal where something is uncertain…can be a really good idea, just because most acquirers are not accounting professionals,” said Bruffey.

Proof of cash

A proof of cash report is similar to a QoE report but slightly less extensive. Proof of cash reports review ledger cash transactions and reconcile them with actual cash balances. This ensures accurate cash reporting by the seller or target business and can uncover discrepancies. These could include unrecorded transactions or, in a worst-case scenario, fraudulent activity.

Review benchmarks in your industry

James Chittenden, small business strategist at OnceClickAdvisor, recommends reviewing benchmarks in a business’ industry for greater insight. 

“Get familiar with benchmarks in your industry and in your area. For example, what are the average profitability margins for plumbing companies in the Chicago area with $500,000 - $1 million in sales? Compare your business with the benchmarks, and find out why the business underperforms or overperforms,” he says. 

Properly addressing financial red flags

While knowing what to look for in a company’s financial statements is one part of the equation, the other part is being able to address the red flags. Here are some considerations when analyzing red flags and determining how to address them if you plan to continue with the transaction.

Understand your capital requirements

With many SMB transactions leveraged through SBA financing, the biggest concern for new owners is ensuring they “have enough money each month to make their payments,” Bruffey explained to Mainshares. A key part of addressing debt-related red flags is understanding your debt-service coverage ratio, which measures how many times a firm’s current period’s cash flows will cover the payment obligations.

Another aspect of managing debt issues is ensuring you have enough working capital to operate the business at a comfortable cash level. To figure that out, Bruffey recommends buyers look at two factors: how much the business has historically on hand for working capital and its monthly burn. 

“If you know what your monthly burn is, you can basically figure out how much working capital you need at any given moment,” Bruffey said.

Together, these factors can tell you how cash-dependent a business has been and how much its current debts erode that capital. 

Manage cash flow appropriately

Cash flow management can differ from industry to industry. Take retail businesses, for instance. Some retail stores are only profitable in the months around the holidays. To survive through the slower months, owners ensure cash flow is properly managed to account for revenue declines throughout the year. Preparing a cash flow projection for the coming year based on the financials is one practical way to help manage your liquidity. 

Open lines of communication

When dealing with limited financial information or a discrepancy between the seller-reported EBITDA and your QoE findings, Silensky recommends communicating clearly with the seller. “Ultimately, all red flags [are] just a question of proper communication with the seller,” he explained. 

Sometimes, communicating openly means addressing an elephant on the balance sheet, revisiting an initial purchase price offer, or adjusting a multiple. Other times, it could be a candid conversation about how the current owner views their business. Either way, candor is helpful in these transactions. 

Ensure red flags are reflected in the deal structure

Regardless of the type of financial red flag you’ve discovered in due diligence, your underwriting should reflect any added risk.

This may mean lowering the valuation multiple you’re willing to pay or changing the terms from a stock sale to an asset sale. You may also need to apply for a working capital loan to increase short-term liquidity or require the seller to roll some equity to make sure incentives are aligned.

These considerations can help lower the associated risk of the transaction and ensure a smooth transition after closing. 

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Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.