Should I worry if a seller cannot explain a drop in margins?

A margin that has fallen is not automatically a bad sign, since costs, prices and product mix all move. What matters is whether the owner can show why. BDC’s due diligence guidance tells buyers to look at trends in sales, profit margins and other data, and says that if sales are trending downward and the vendor cannot convincingly explain why, you may need to rethink the transaction.

Ask for the breakdown behind the number

Start by asking where the change happened. Request the margin by product or service, by customer and by period, and compare it with the cost records for the same months. Ask what the owner changed in that period: suppliers, pricing, staff, hours or customers. Ask the owner to point to specific events. If the answers are vague, ask for supporting documents such as invoices and supplier price lists.

Have an accountant test the explanation

BDC says an accountant can help you analyze the company’s financial records, and that an accountant can prepare a quality of earnings report. According to BDC, that report goes beyond standard financial statements to identify and adjust for non-recurring items, accounting irregularities and risks. BDC also asks whether the figures match the information from the owner and whether tax returns match the financial statements. A mismatch deserves an explanation in writing.

Decide what the answer means for your offer

If the drop has a documented, one-time cause, it may not change your view of the business. If it reflects a lasting cost or the loss of a customer, it may change what you are willing to pay or whether you proceed. BDC notes that if the seller cannot provide the documents you ask for, you may have a chance to renegotiate the price. That is a decision for you and your advisers, not something this page can make. See also what a red flag in due diligence can look like.