The New Year has arrived, and you have decided that the route to creating the financial freedom and work/life balance you have always been after is to purchase a business.

You have always thought about owning a small hardware store and the family business just down the road is now up for sale. Your passion for DIY and the thought of standing behind the counter inspires you enough to consider throwing in the towel on your corporate career, cashing in your savings, taking a loan and giving this business your best shot.

Throughout my career I have had the opportunity to both sell businesses (my own and others) as well as to facilitate the purchase of businesses.

If I can give you any advice it would be this “do your due diligence”, in fact let a professional do it for you. What you read here can also be applied when looking at buying a franchise.

Due diligence includes asking both yourself and the seller some tough questions.

The problem is, you more than likely won’t know what questions to ask.

One of the first things you need to understand is how the value of a business is derived. Usually this would be a combination of future maintainable earnings X a multiple of these earnings adjusted for risk (deriving a multiple is a topic on its own).  This is at its most basic!

Remember that valuing a business is an art and not a science.  There will be plenty of factors you will need to consider when looking at purchasing the business.

Look at the business and the financials of the business objectively.  Use your head and not your heart.  Often buyers want a business so badly that they ignore any potential red flags.  Question any gaps or anomalies in the data and consider the maintainability of the earnings.

You will need to understand that future maintainable earnings is calculated from a number of components that will essentially give you a figure for earnings before tax (EBIT).

The first component to look at is revenue, this is what the business turns over on a monthly or annual basis.  Look closely at these figures and make sure you understand how this income has been derived.

Are the customers repeat customers?

  • Do you have to work for your customers and is each sale a new sale to a new customer?
  • Are there seasonal fluctuations in the revenue?
  • Are there any unusual amounts in any of the periods that are considerably higher than any others? This may be an indicator of a “once in a blue moon” sale that is not likely to be repeated.

The next component would be the cost of sales (COS). COS will help you derive the gross profit (GP) which will then allow you to determine how much of your overhead can be absorbed as well as provide some profit.

You will need to ask:

  • Will the supplier give me the same pricing after purchase?
  • Will the supplier give me the same credit terms after purchase?

As a business owner you will want to sell your goods before you have to pay for them. At the same time if your COS increases you will have less GP to apply to your overhead costs.

Determining what your overhead costs are and will be is critical. Usually when valuing a business non-essential or excessive overhead costs are stripped out (as they should be). One of the largest overheads costs will be your labour costs which usually make up 30% or more of overhead costs.  Often labour costs are underestimated by the purchaser and sometimes understated by the seller.

Have a close look at the balance sheet.  If accounts receivable looks high, ask to see an age analysis and as how likely it is that the debt will be recovered.

Make sure you know what inventory you are buying and how long that inventory has been held for.

Check the non-current assets you will be acquiring and make sure you know how much useful life they have left in them.  You may find yourself having to make a large capital purchase after purchasing the business if the assets were close to the end of their useful life.

Do you understand the business and how things are done?

Are there written policies and procedures?

Remember that the best businesses have everything documented.

Unfortunately, most prospective buyers don’t seek professional advice and don’t see the value in allowing a professional to do a due diligence on the business.

Sadly, this may cost you as the purchaser hundreds of thousands of dollars in the future.

I would consider money spent on a professional due diligence money well spent and a solid investment should you decide to go ahead with the purchase or not.

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