As you review the proposal, there are twelve significant areas that you need to analyze. Once you feel satisfied that you have answered all the following questions and still feel positive about the proposal, make an appointment with your accountant or business consultant and review the proposal together. If you do not understand some of the terminology, turn to the glossary of terms in Chapter 3.
1. Is this business profitable? A business’ profitability can be great- ly determined by interpreting the financial statements. Therefore, ensure that they are prepared by a reputable accounting company. If possible, obtain two years’ statements. They will show the assets, liabilities, equity and growth of the business, sales, cost of sales, operating expenses, the wages
paid to staff and owners, and subsequent profits or losses. Your accountant can help you analyze them.
Pay for the Profits:
Be prepared to pay for a well-established, profitable business. It’s worth it, because you will have an immediate guaranteed income. Take into account the hard work that someone else has put into the business. They have experienced the mistakes and the learning curves—that alone has to be worth something.2. Can the business support your wage requirements? If a business is not incorporated, the financial statements will not show the wages paid to the owners. Instead, the business should reflect a bottom line net profit high enough to satisfy the wage that you would like to take from the business. If it is incorporated, owners’ wages will show as management fees. Wages will also be broken down into the various employee categories, such as manufacturing, sales, and office.
First decide which role you and your family or partner will play in the business. Then look at the wages paid out each year on the financial state- ments. This gives you an idea of how much wage overhead the business can support. Take into account the profits (if any) after all expenses and your wage. They can be used as additional wages, as long as your wage require- ment does not negatively affect the business’ cash flow. To ensure the busi- ness can support your wage requirements, draw up an annual household budget to determine the amount that the business must provide you with.
Examine your personal expenses and include expenses that will occur in the near future.
3. Are sales seasonal, increasing, or decreasing? When you look at the annual sales on a financial statement, they don’t reflect season- al or month-by-month fluctuations. Ask the vendor to supply a two-year monthly sales breakdown so that you can assess seasonal fluctuations and decreases or increases in sales. The case study about Mel’s Bookkeeping and Tax Services on the next page gives an example of a business that when closely examined, experiences definite sales fluctuations.
CASE STUDY: Mel’s Bookkeeping and Tax Services
Mel was selling a small bookkeeping and tax business showing annual sales of $68,5000. The business incurred monthly costs of $2,000, and Mel drew $2,500 a month. The sales looked good, but when analyzing them month-by-month, this was the picture.
Monthly Sales for Mel’s Bookkeeping and Tax Services
January $ 6,000 July $3,500
February $ 7,000 August $2,500
March $ 9,000 September $4,000
April $12,000 October $5,000
May $ 9,000 November $3,000
June $ 6,000 December $1,500
Analysis
Because the bulk of the bookkeeping income was from small businesses having their annual books and income taxes prepared, the first few months of the year were busy. But for five months, the business did not make enough to cover overhead and wages. Not only would the first six months be stressful with a heavy workload, it would also be difficult to plan cash flow to keep the business going for the rest of the year and plan to pay per- sonal tax installments. One solution would be to train clients to bring in their books quarterly to even out the workload. Many businesses experi- ence these seasonal fluctuations.
4. Are you paying too much for this business? The sale price of a business is based on the value of the assets—equipment, buildings, furni- ture, and inventory—plus goodwill. The business should reflect the ability to generate a steady wage. There is usually room to negotiate on the pric- ing, particularly if you and your accountant have performed a thorough analysis of the proposal.
5. Are the assets worth what is being asked? If you purchased the shares of an incorporated company, the assets are usually sold at book value as listed on the financial statements. “Book value” is the cost of the assets less accumulated depreciation over the years. With a proprietorship, the vendor may put an unrealistically high value on the assets or show you misleading appraisals for the value of larger equipment. Never pay more than fair market value.
No matter what an appraisal says, equipment is really worth no more than its book value at the time of sale. This is how banks evaluate assets on loan applications. Some vendors and purchasers arrive at an agreed pur- chase price somewhere between book and market values. Evaluating the inventory will require astute knowledge of what you are buying. People inevitably end up with worthless inventory or overpriced equipment. See Rule #2 under “Seven rules for a successful purchase” later in this chapter for more information.
6. Is the goodwill realistically priced? “Goodwill” is the term used to place a value on the intangible worth of the business. The figure is based on the business’ reputation, its stability, and its ability to generate both profits and a reasonable wage for the owners. Your accountant can help you decide whether the goodwill price is reasonable. If you are pur- chasing a franchise, the goodwill is usually a set amount and there is little room for negotiation.
One common calculation bases goodwill on the money the business gen- erated as an owner’s wage within a one-year period (although some vendors use a two-year calculation), plus any net profits. If the vendor is drawing an annual wage of $40,000, or $65,000 with a spouse, then the goodwill could be as high as $65,000. If the business is still making a profit after these wages are drawn, then the goodwill may be worth even more. If it is losing money after these wages are drawn, then the goodwill amount should be reduced.
7. Do you have the experience to keep the business profitable?
A new business is a challenge, and as the owner, you are responsible for its suc- cess. Ask the vendor about the role he or she plays in the business. Can you adequately fill these shoes or afford to pay someone else to? Remember to address those four main roles in business—operations, administration, sales, and marketing.
CASE STUDY: Missing the Mechanics of Business
Tony and Pradeep purchased a mechanical repair business. Pradeep had some mechanical experience, gained mainly from tinkering and a short night school course, while Tony was meticulous at paperwork. He had operated his own microbusiness for many years.
When they took over the store, things didn’t go quite as planned. The operation required a vast knowledge of different components, and the paperwork, accounting, inventory management, sales, and marketing were more than a full-time job. Extra staff was hired to keep the business opera- tional. The first two years produced a dramatic loss due to mismanagement at all levels. The stress caused Tony and Pradeep to argue and led to the eventual downfall of the business.
8. Could this business be expanded? Diversification is the key to growth, and planned growth is the key to success. How else could this busi- ness expand or diversify into other areas? If it is a retail store, what other lines or services could be introduced? For a service business, how could you expand, increase, or improve this service? For a seasonal business, how could you diversify during the quieter periods? If you cannot expand or diversify, what else can you do to increase sales?
9. What mistakes did the owners make that you should avoid?
Your accountant will highlight any areas of concern in the financial statements.
The balance sheet may show too much inventory, a growing bank overdraft, or perhaps too many outstanding accounts receivables. Government taxes may be overdue. The statement of income and expenses will highlight areas of over- spending, such as wages or advertising. The profit margins after cost of sales may not be as high as you have been told. Ask the vendor these questions.
From there, you have to decide whether you could run the business more effi- ciently. What would you change? What can be changed? What will take time to change? What would such changes cost?
10. What is the life expectancy of this business? Your busi- ness needs a built-in longevity to survive. Research the history of the industry, study consumer trends, and be reasonably certain that your busi- ness will still be performing profitably in the next five to ten years. For example, one long-term business trend is computer servicing, repair, and customer education. Few businesses can survive without technology these days, and many owners do not fully understand how to use the various software programs.
Consumers are fickle. They drive the world trends and trends change quickly. Some businesses do not continue to grow because they refuse to keep up with both trends and technology. Is the business you are purchasing keeping up with these changes? How will future trends affect its growth?
11. Who makes the most profit—the franchiser or you?
With a franchise, you need to know exactly what percentage of profits is going into the franchiser’s pocket. You will probably pay a percentage of gross sales as a royalty or toward advertising costs. Some franchises require an annual fee for overhead costs. With an existing franchise chain, those numbers will already be available to study.
You will pay a franchise fee, or goodwill on purchase, and depending on the franchise’s reputation, this can be tens of thousands of dollars. In some cases, franchises make more money than their operators. Think about how much ice cream or how many cups of coffee you have to sell to cover these costs and the time and labor involved.
12. Are projections realistic? Projections of future income, expens- es, and profits should be based on past performance, factoring in the pres- ent and future economy and trends. Few projections live up to their claims because too many factors can change at any moment. So don’t take them at face value. It makes more sense to study past financial statements. If they reflect a loss, yet the projections reflect healthy profits in the coming year or two, ask what magic formula the business will be using to achieve these figures and market that formula yourself—you’ll get rich a lot quicker!