Sanity Check - Buying a Business

Willard Michlin

Posted Date: Monday, October 15, 2007 | Viewed: 96

Posted In Category: Article Directory > Business and Finance > Entrepreneurialism Articles

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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 1 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.

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

2. 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’s 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* $ _________________ (--)
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 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.

Calculation notes:
1. Taxable profit from operation $_________________ (+)
2. Cash $_________________ (+)
3. Owners Salary $_________________ (+)
4. Salaries of non-working family members $_________________ (+)
5. Amount over the fair market value of wages
of working Family members $_________________ (+)
6. Family Auto Expenses $_________________ (+)
7. Family Telephone Expense $_________________ (+)
8. Family Office Expense $_________________ (+)
9. Health and Life insurance of
Any/all family members $_________________ (+)
10. Pension plan/profit share family members $_________________ (+)
Total Seller Discretionary Earnings: $_________________

Return on Investment: We need to have this stated as a dollar amount in Formula two. ROI is calculated as follows:

Cash Requirement X “a Percent” - the greater the risk, the higher the percent

First we must determine what the interest rate return we wish on our investment. This is a very subjective percentage and a change in this number can change the whole result of this analysis. If it is of any help, many financial investors in “Corporate America” feels they need to get a 20% return on their invested capital. Companies do not always make money and therefore the possible loses are built into the ROI. Some of the reasons are: companies are bought and go broke, overseas competitions causing expectations of growth and income not to be met, and lastly government regulations periodically close whole industries. These are just some of the many risks involved in owning a business.

Putting your money in a bank has little risk, because the Federal Government insures your deposits in the bank. The stock market has a lot of risk that many people do not fully understand, causing them to accept a long term ROI of 10-13% from mutual fund investments. A 95% drop in stock prices like the dot.com stocks or what happened when we had the oil embargo in 1992 are indications that the stock market can be a much higher risk than people realize.

I personally feel that owning your own business and buying real estate are much lower risks, providing a much higher return. The proof of this can be found in the number of people who got rich in real estate and the over 25 million small business owners across this country.

Figure out what ROI you want and insert this number as .20 amount to represent 20% or .06 to represent 6% ROI. This is an annual return on invested money.

Once you have a percentage return on your investment we need to multiply it by the Cash requirement in order to come up with a dollar amount return needed. This restated is Dollars invested x percentage (stated as a decimal) = Dollar return on investment.

Examples:

1) Investment of $50,000.00 @ 6% Return on Investment (ROI) would be calculated as follows: $50,000.00 X .06 = $3,000.000 (Dollars return on investment)

2) Investment of $50,000.00 @ 20% Return on Investment (ROI) would b

Article Tags: business, sanity, check, buying

Willard Michlin is an Investor, Business Broker, California Real Estate Broker, Accountant, Financial Distress Consultant, Well knew Public speaker and Administrative/Business Consultant. He can be contacted at his Ventura, California office by calling 805-529-9854 or by e-mail at kismetrei@earthlink.net. See other article by Willard at http://www.kismetbusinessbrokers.com

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Sanity Check - Buying a Business

Willard Michlin

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