Details in this case study have been generalized and no identifying information is included.
A wholesaler came to market advertising roughly $1.4 million of seller's discretionary earnings. The CIM was well put together and the recast was internally consistent. Nothing in it looked wrong on a first read.
The thing that did not sit right was the trend. Sales were declining year over year, and gross margin was improving each year at the same time.
That combination is not impossible. A distributor can shed low-margin accounts, or renegotiate with suppliers, or shift mix toward better products. But it is unusual enough that it is worth understanding before you accept it, because the more common explanations are less flattering.
Management explained it directly when asked: the business had been intentionally running its inventory down and carrying less stock each year.
The books were on a cash basis. Ownership had, to their credit, kept a supplemental schedule of actual year-end inventory balances, and they provided it.
That schedule was the whole engagement.
On a cash basis, results tracked reasonably close to the CIM. Cost of goods sold reflects what the company paid for inventory in that period, not what it sold. A company drawing down stock is selling goods it paid for in an earlier year. Cash out goes down, revenue holds, and margin looks like it is expanding.
Adjusted for the actual inventory movement, the picture inverted. Instead of improving margin, the company was losing margin every year. The earnings the buyer was being asked to pay a multiple on were partly a balance sheet liquidation, and a buyer cannot keep selling inventory indefinitely without buying more.
The buyers walked.
It is worth being fair about this. Brokers will tell you cash basis is perfectly acceptable in the small business space, and to a large extent that is true. Banks underwrite off cash-basis financials. Most QoE reports start there. The tax return is on that basis. Nobody is doing anything improper.
The issue is that cash basis measures cash movement, and cash movement and operating performance come apart whenever the balance sheet is moving. Inventory is the most common case. Deferred revenue and a change in customer payment terms do the same thing.
Accepting cash-basis results is fine. Accepting them without checking whether the balance sheet moved underneath them is not.
You do not need a full engagement to spot the pattern. Three checks get you most of the way:
The adjustments that change deals are usually not hidden. They are visible in the trend, and the trend is visible in the CIM. What is missing is the second question.
Sales down and margins up is a story. Sometimes the story is a better-run business. Sometimes it is a business selling its own shelves. The difference is worth finding out before closing rather than in the first quarter of ownership, and finding it out is not expensive relative to what it protects.