The Hidden Realities of Financial Statements: Why Businesses Aren’t Always What They Seem
In the world of acquisitions, financial statements tell a story—but whether that story is a masterpiece or a fabrication depends on the reader’s ability to dissect the numbers beyond face value. On the surface, a business may appear stable, even profitable, but for those who understand the intricacies of forensic financial analysis, the truth often reveals something entirely different.
The reality is simple: financial statements are not designed to show you the truth; they are designed to show you what the seller wants you to see.
Those who rely purely on EBITDA multiples or surface-level cash flow analysis are not investors; they are marks—ripe for overpaying on a business that, when stripped of its financial veneer, may be hemorrhaging cash or on the verge of collapse.
This is why true investors dig deeper.
Forensic Accounting: Unmasking the Illusion of Profitability
At first glance, many businesses appear to generate healthy earnings. The CIM (Confidential Information Memorandum) may show a business with "consistent profitability," a solid customer base, and a seller who is "retiring" after years of success.
But profitability is an illusion if it’s built on non-recurring income, artificial adjustments, or aggressive cash extraction.
Consider the following:
Net income alone is useless. It’s the most easily manipulated number on a financial statement. A business can show "profits" while cash flow is negative.
Retained earnings should grow if the business is profitable. If a company claims consistent earnings yet has negative retained earnings, someone has been pulling money out faster than the business can generate it.
Dividends in a loss year? A red flag. If a business reports a loss but still issues dividends, the money has to come from somewhere—delayed vendor payments, increased debt, or creative accounting.
In a recent analysis, we came across a business where dividends exceeded retained earnings, a classic sign that the seller was extracting maximum value before exiting. This is a near-certain indicator that post-sale, the business would either require significant reinvestment or suffer immediate operational strain.
The Danger of "Other Income" and Adjustments
Many buyers evaluate businesses based on Seller’s Discretionary Earnings (SDE) or EBITDA, which are often adjusted to "normalize" the business. These adjustments, however, should be scrutinized heavily.
Non-recurring income should be eliminated from valuation. If a company reports an unexpected windfall from a legal settlement, government grant, or insurance payout, that revenue does not reflect the actual earning power of the business.
Expense recovery: What are they hiding? If a business lists "expense recovery" as part of its income, this often means they were reimbursed for something that shouldn't have been an expense in the first place. This could be a sign of previous lawsuits, accounting irregularities, or one-time deals that artificially inflate earnings.
CEBA Loans, Grants, and COVID-era Windfalls. Many businesses received government aid or forgivable loans during the pandemic, temporarily boosting their financials. If those funds are baked into earnings calculations, the company’s true revenue potential is significantly lower than advertised.
Key takeaway: If you remove all non-operational sources of income and the business suddenly looks unprofitable, it was never truly profitable to begin with.
Cash Flow vs. EBITDA: Where the Real Truth Lies
The fastest way to separate a legitimate business from a financial time bomb? Cash flow analysis.
While EBITDA can be manipulated through timing of expenses, capitalization of costs, and accounting choices, cash flow is far more difficult to disguise.
Some immediate warning signs include:
Large accounts receivable (AR) relative to revenue. A business with growing AR but stagnant revenue might be overextending credit to customers, delaying cash inflows, or worse—struggling to collect.
Negative working capital trends. If accounts payable are rising significantly faster than revenue growth, the business may be delaying payments just to keep the lights on.
CapEx Deferral. If a business is profitable yet has zero spending on maintenance or equipment, ask yourself: is this business running on deferred expenses that will hit the next owner?
One of the most dangerous traps buyers fall into is believing that EBITDA represents cash flow. It doesn’t. A business that "profits" but has no cash is a business on the verge of collapse.
When a High Asking Price Doesn’t Match the Risk Profile
Valuing a business isn't just about multiples; it's about risk-adjusted pricing. If the business has cash flow volatility, owner dependency, or operational inefficiencies, the valuation should reflect those risks.
Some key risk-adjusted valuation principles:
A high-reliability business with stable, repeat revenue may justify 3.5x–5x EBITDA.
A low-margin, owner-dependent business with erratic cash flow should be valued closer to 1x–2x earnings.
A business that has never been profitable under proper adjustments should be valued at or below net asset value (NAV).
If a business presents systemic financial mismanagement, over-extraction by the owner, and lacks cash reserves, it’s not worth paying full price—it’s worth pennies on the dollar.
The Aggarwal Holdings Approach: We Don’t Buy Illusions
The takeaway here is clear: We do not buy businesses based on surface-level earnings.
We dig deep into financial statements to uncover inconsistencies, distortions, and mismanagement.
We adjust for non-recurring income and hidden liabilities to determine true earning power.
We evaluate businesses not just based on where they are today, but on where they can be with proper leadership.
Many buyers overpay for businesses that, under proper analysis, are barely worth liquidation value. Those who understand forensic accounting, however, can acquire businesses at massive discounts, structure deals to hedge risk, and create exponential returns.
This is how real investors separate perceived value from actual value.
