Here at Nextoria, our team spends most of our waking hours helping founders sell their e-commerce companies for the highest possible price. One of the first foundational questions we ask each new client is, “What type of accounting does your company use?” We won’t bury the lead: If you want to sell your e-commerce business, the answer to this question should always be accrual based accounting.
As you build your company, you have two choices for accounting methods: cash basis or accrual basis. Before your eyes glaze over from boredom, understand that every aggregator, family office and strategic investor we work with cares about this issue and you absolutely should too. So take note now so that you are in the best possible position when you are in negotiations to sell your e-commerce company!
Cash vs. Accrual Accounting
Your financial statements are like an x-ray of your company – they capture your financial health with a two-dimensional image that lets an observer diagnose issues without having to develop the same intensive understanding about your business that you have. Cash and accrual accounting provide different perspectives on the same information due in large part to the respective timing each uses to record transactions. Cash accounting tracks cash as it moves in and out of your company. Accrual accounting, on the other hand, captures revenue when you earn it and expenses when you incur them. This may seem like a small difference, but the impact it can have on your valuation is HUGE!
There are pro’s and con’s to both cash and accrual based accounting. We will give the devil its due – cash accounting is typically simpler than accrual accounting. If you run a cash intensive, small business, and you have no interest in selling your business in the future, using cash accounting with a few well constructed spreadsheets can be ok. Accrual accounting, conversly, can be more complex than cash accounting but captures details that cash accounting will miss and is widely regarded as a more accurate presentation of financial information.
Regardless of where you are doing business, you should be using accrual accounting. In fact, accrual accounting is actually required by most reporting standards. In the United States, all public companies, and the vast majority of private companies with investors or lenders, are required by law to use accrual accounting to be compliant with Generally Accepted Accounting Principles (GAAP). Outside of the US, the International Financial Reporting Standards (IFRS), a set of accounting rules for the financial statements of public companies used in more than 110 countries around the world including the EU, require accrual accounting.
The Risks of Bad Accounting
Cash accounting can cause considerable confusion when assessing your business’s profitability. Using accrual accounting is the only way to meaningfully track your costs and conduct an apples-to-apples comparison over different time periods. Recording income when it is earned and costs when they are incurred allows you to maintain a firm understanding of your business’s margins at all times. Without this type of analysis, you are flying blind. And what happens when you’re flying blind? Sometimes you luck out, but frequently you crash something very expensive – in this case your business. Without accrual accounting you cannot have an accurate understanding of your profit margins, and you are likely to leave a lot of money on the table when you are ready to sell your business.
Let’s consider a simple, real world example to show you how using cash can underestimate your profitability and cost you money during an exit. Take two companies – Company A and Company B.
Company A uses cash accounting, recognizing the full amount of COGS when it purchases its inventory for the next three months. As you can see, under this method COGS is realised in a one very large chunk, which distorts Company A’s profit margin.
Now let’s consider Company B. Company B works with some very savvy M&A advisors who recommended early on that they use accrual accounting. Therefore, Company B realises COGS as sales are made, rather than when purchasing inventory. This smoothes out the gross profit calculation and avoids single transactions distorting Company B’s profit margin.
Same sales, same COGS, different profit margins?
Company A and B are virtually the same company. They make the exact same monthly revenue and have the exact same COGS: They both order $17,000 worth of inventory every three months, paying in advance.
But because Company A uses cash accounting, it looks like its profit margin is just 22.7% instead of 50% (as accurately calculated by Company B).
It should be easy to see by now that using cash accounting will almost certainly cause you to leave money on the table when you sell your company. The difference in timing between when you incur costs to purchase inventory and when you record income from your sales is part of doing business as an ecommerce company, and you should only use an accounting method that captures that reality. Don’t cost yourself hard earned money – start using accrual accounting today.
Build Your Company’s Financials on a Firm Foundation
Our team regularly encounters businesses whose clean, accurate financials make the difference between a smooth exit and a complicated, painful slog. We have seen some companies whose financials are such a mess that the underlying business is virtually unsellable. We suggest working with vetted accounting service providers who specialise in e-commerce. These providers can quickly review your business’s financial statements, convert your accounting from cash to accrual if needed, prepare monthly P&Ls for your company and fill in any gaps that would otherwise present an obstacle to the sale of your business.
We approach every client relationship with the hope that all financial reports will be complete, detailed and use accrual-based accounting. However, in most cases, our clients need the help of a skilled accountant who specialises in e-commerce companies to be ready for an exit. Save yourself a tremendous headache by having a qualified financial service provider help you with accrual accounting today.
If you would like to discuss the mechanics of selling your e-commerce business in more detail, or would like us to help refer you to a qualified financial services provider, please contact us at email@example.com