Business Evaluation Pitfalls: How to Evaluate the True Worth of a Business: Sanity Check-Buying A Business

Getting the True Value of a Business.

In the business broker community there is a review process that helps a buyer determine if a business purchase makes sense or not. This check can be done by a Fortune 500 company where everything is figured down to the penny and takes 1000 hours of research or it can be done by a small main street shop buyer who figures it out in one hour. Each item in this review process requires a decision. This decision can be based on extensive research or just on a reasonable guess. The beauty of this process is; how long you want to spend on doing this activity is totally up to you.

As we review this process, I will explain the variables of this system so you can make the necessary decisions where needed. Remember, this is only a tool to help you make decisions about a business purchase; it is not a sure-fire foolproof system. I will just lay it out for you and you make your own decision as to the validity of this formula for analyzing a business purchase that you may want to make.

Business Evaluation Pitfalls

The sanity check requires two mathematical formulas, which require dollar amounts or other numbers to be entered in each formula.  The math is calculated and then the results are compared against the purchase price.  If it doesn’t work out the way you wanted, you have the option of then going back and change some of the numbers and do the calculation a second time.  The two formulas are:

  1. SP + WC – BF = CR   Sale Price + Working Capital – Borrowed Funds = Cash Requirement
  • SDE – FMW (FO) – DS – ROI = Extra Profit/Loss     Sellers Discretionary Earnings – Fair Market Wage (for the owner) – Debt Service – Return on Investment (Cash Requirement x Interest rate (Stated as a Percentage) = Extra Profit/Loss

Since each item in the formula needs to have a dollar amount determined, we will define the terms and then discuss how the dollar amount is derived at.

Terms Definition:

Sale Price: The price that is being asked for the business or the price the buyer is thinking of offering. Depending on when you do this analysis.  If you are trying to determine an asking price you would calculate all the other numbers in these two formulas to determine what should be your offering price.  We will do examples to make this clear later in this article.

Working Capital: The short-term assets minus the short-term liabilities are the accounting definition.  The simple explanation would be the amount of money necessary to be invested by the buyer to run the daily operations of the business, once purchased. This would include monies tied up in inventory, and accounts receivables.  Money invested to pay the landlord’s or utility company deposits. Also included is the money spent on the business purchase to cover the loan origination costs and purchase escrow fees when buying the business. It is the total funds invested into the business to keep it running.  The down payment given to the seller is not part of this number, since it is included as a separate item.

Calculation notes:

  1. Cost of inventory: $_________________ (+)
  2. Accounts receivable: $_________________ (+)
  3. Landlord deposit: $_________________ (+)
  4. Utility Deposits: $_________________ (+)
  5. Escrow fees to purchase: $_________________ (+)
  6. Loan origination costs: $_________________ (+)
  7. Short term liabilities* $ _________________ (–)
  8. Total Working Capital $_________________

*Short-term liabilities are defined as liabilities that are to be paid off within 1 year – accounts payables and the part of any notes payable that are to be paid within 1 year.

Borrowed Funds: The loan made for a business purchase from a bank or private party. The private party can be the seller or some friend or relative who might be willing to make a loan. This is borrowed money that must be paid back to someone at some time in the future.

Cash Requirement: This is the invested cash required to both buy a business, and working capital-to run the business. The amount of cash needed to make the business purchase and run the operations of the business after deducting all borrowed funds, regardless of the source.

Sellers Discretionary Earnings / Owners Total Benefits: This is the total of all the non-business related benefits going to a business owner or his family on an annual basis that have been paid for, by the business. Included in this is definition are taxable profit from operations, unreported cash income, owners salary, salaries to non-working family members, any amount over the fair market value of salaries paid to working family members, family auto expenses, family telephone, family office expenses, health and life insurance for any or all family members, pension plan/ profit sharing contributions paid for the benefit of family members. This can also be stated as the reason why most people go to work everyday; they get family support for working.

Due Diligence Defined: The phrase is composed of two words.  Due, which the dictionary defines as “proper or adequate” and Diligence, which is defined as “Degree of care or caution expected of a person. Especially as a party to an agreement.” Caution: is the watchword in this definition.

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