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Investment InformationSanity Check - Purchasing a Business
by:
Willard Michlin
In the business broker community there is a review process that helps a customer determine if a business purchase does sense or not. This check can be done by a Fortune 500 institution wherever
everything is patterned
down to the penny and takes 1000 hours of research or it can be done by a small main street shop customer 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 simply on a reasonable guess.
The beauty of this process is; how long you want to spend on doing this activity is altogether up to you. As we review this process, I will explain the variables of this system so you can do the necessary decisions wherever
needed. Remember, this is only a tool to help you do decisions simply about a business purchase; it is not a sure-fire foolproof system. I will simply lay it out for you and you do your own decision as to the validity of this formula for analyzing a business purchase that you may want to make.
The Saneness check requires two mathematical formulas, which require dollar amounts or else amount to be entered in each formula. The math is calculated and then the results are compared against the purchase price. If it doesn’t activity out the way you wanted, you have the option of then going back and change several of the amount and do the calculation a second time.
The two formulas are:
1. SP + WC – BF = CR
Sale Cost + Working Capital - Borrowed Funds = Cash Requirement
2. SDE – FMW (FO) – DS - ROI = Extra Profit/Loss
Sellers Discretionary Earnings - Fair Market Wage (for the owner) - Business enterprise obligation Service - Return on Investment (Cash Requirement x Interest rate -Stated as a Percentage) = Extra Profit/Loss
Since each item in the formula of necessity
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 cost that is being asked for the business or the cost the customer is thinking of offering. Depending on once
you do this analysis. If you are trying to determine an asking cost you would-be calculate all the else amount in these two formulas to determine what should be your offering price. We will do examples to do this clean later in this article.
Working Capital: The short-term assets minus the short-term liabilities is the accounting definition. The simple explanation would-be be the amount of money necessary to be invested with by the customer to run the daily operations of the business, once purchased. This would-be include monies tied up in inventory, and accounts receivables. Money invested with to pay the landlord’s or utility company’s deposits. Likewise enclosed
is the money spent on the business purchase to cover the loan origination cost and purchase written agreement
fees once
buying the business. It is the total funds invested with into the business to keep it running. The down payment given to the merchant is not part of this number, since it is enclosed
as a separate item.
Calculation notes:
1. Cost of inventory: $_________________ (+)
2. Accounts receivable: $_________________ (+)
3. Property owner
deposit: $_________________ (+)
4. Utility Deposits: $_________________ (+)
5. Written agreement
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 inside
1 year – accounts liabilities
and the part of any notes due that are to be paid inside
1 year.
Borrowed Funds: The loan ready-made for a business purchase from a bank or private party. The private party can be the merchant or several friend or relative who strength
be willing to do a loan. This is borrowed money that must be paid back to causal agency at several time in the future.
Cash Requirement: This is the invested with cash required to several buy a business, and working capital-to run the business. The amount of cash required to do 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. Enclosed
in this is definition are nonexempt 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 automotive vehicle 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 likewise be expressed
as the reason why most folk go to activity everyday; they get family keep for working.
Calculation notes:
1. Nonexempt profit from operation $_________________ (+)
2. Cash $_________________ (+)
3. Owners Pay $_________________ (+)
4. Salaries of non-working family members $_________________ (+)
5. Numbers over the fair market value of wages
of working Family members $_________________ (+)
6. Family Automotive vehicle 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 Merchant Discretionary Earnings: $_________________
Return on Investment: We need to have this expressed
as a dollar amount in Formula two. ROI is calculated as follows:
Cash Requirement X “a Percent” - the greater the risk, the higher the per centum
First we must determine what the interest rate return we will on our investment. This is a really subjective percentage and a change in this number can change the whole result of this analysis. If it is of any help, many an business enterprise investors in “Corporate America” feels they need to get a 20% return on their invested with capital. Companies do not always do money and therefore the possible loses are built into the ROI. Several of the reasons are: companies are bought and go broke, overseas competition effort expectations of growth and financial gain
not to be met, and in conclusion
government regulations sporadically
close whole industries. These are simply several of the many an 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 an folk do not fully understand, effort 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 once
we had the oil embargo in 1992 are indications that the stock market can be a more higher risk than folk realize.
I in person
feel that owning your own business and buying real estate are more lower risks, providing a more higher return. The proof of this can be found in the number of folk 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 with money.
Once you have a percentage return on your investment we need to multiply it by the Cash requirement in order to move up with a dollar amount return needed. This restated is Dollars invested with x percentage (stated as a decimal) = Dollar return on investment.
Examples:
1) Investment of $50,000.00 @ 6% Return On Investment (ROI) would-be 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-be be calculated as follows: $50,000.00 X .20 = $10,000.00 (Dollars return on investment)
Debt Service: The reason we need this number is because this is a business enterprise expense of owning a business. It is not an operative
expense of the daily business operations but if you have debt, in your business, you must be able to do the payments, out of the business operations profit. Ordinarily this payment is mostly interest and a smaller portion is the principal reduction of the loan balance.
Most professionals deduct the whole payment once
doing this analysis, because the business must generate enough profit to do the whole payment. My personal preference is to simply deduct the interest portion and to add the principal portion of the payment to working capital amount needed. This counts as more money being put into the business simply like funding inventory and/or accounts receivables.
For simple one-hour analyses it is not worth cacophonous up the payment. In the case of a really large principal reduction payment it could be unreasonable to not split it up. It is up to you. You can always try it several ways, since this is a process to raise your understanding, not to move up with a fixed answer of, yes! it is a buy or no! it is not a buy.
Fair Market Wages: This is an amount that the new or old owner would-be be paid, if he were an worker
not the owner. If the owner were the institution salesperson
and likewise the institution controller
working a total 60 hours a week, a reasonable pay would-be have to be determined for each job. As an example only, lets say that an outside salesman, in your industry, could do $40,000 per year. And a controller
ordinarily charges $15 per hour. The salesperson
strength
really well activity 50 hours at this job to earn this salary. If a controller
would-be activity 10 hours per week doing the accounting
that would-be mean 520 hours per year (10 hours x 52) times $15.00 per hour which comes to $7800 per year for the bookkeeper. The two Fair Market Salaries would-be move to $47,800 ($40,000 + $7,800).
Sometimes the market salaries are not so easy to figure. Lets take an owner who owns a 99-cent discount type store. This merchandiser works 70 hours per week behind a counter in the store. You can hire a counter person for $7.00 per hour so this becomes (70 hrs x $7.00 per hour x 52 weeks).
Then you start discussing that this $7.00 per hour counter person would-be not be able to do the buying. You strength
want to amount a buying agent's salary. This can be done or you can simply do simple numbers, effort the pay only based on a counter person’s wages.
DOING THE MATH
By now you have the information to move up with amount to put into the formula. Let us create a scenario. This was a transmission shop. The customers pay COD-upon pick up of the car. The parts inventory is from old transmissions and show on the books as worth nothing. The seller-owner is asking $75,000 for this business that he is able to takes out $50,000 in profit or benefits. In an interview, the owner mentioned that if a customer will put $40,000 as a down payment he would-be carry the $35,000 balance at 5% interest for 5 years. By observation, we can see that the current owner sits in the office and does the bookkeeping, orders parts and does bank deposits. He has a manager who bids jobs and handles production. No one is going out and job on prospective business, which is one thing the owner should be doing with his time, but he is not doing. Lets go through what the amount are with this example.
Math Formula #1: Sale Cost + Working Capital - Borrowed Funds = Cash Requirement
Sales Price: $75,000
Working Capital: The business requires $10,000 cash infusion upon close of escrow, mostly to pay the landlords deposits and start a new marketing campaign.
Borrowed Funds: $35,000
So, the calculation for formula #1 looks like this:
Sales Price: $75,000
Working Capital (+) $10,000
Borrowed Funds (-) $35,000
=Cash Requirement: $50,000.00
Math Formula #2: Sellers Discretionary Earnings - Fair Market Wages For Owner - Business enterprise obligation Service - Return on Investment (Cash Requirement x Percentage) = Extra Profit/Loss
Seller Discretionary Earnings in this case is, let us say, $50,000.00.
Fair Market Wage: You can calculate what you consider fair or you can put all of the else amount into the equation and see what is left for salary. If you like the pay you buy the business, if not you do not. If we were to calculate what the owner’s pay should be I would-be not pay more for what he does. Even as although he puts in 50 hours a week he actually only works 15 hours a week of true production. I am problem solving 5 hours for accounting
and banking and 10 hours for ordering parts and respondent phone calls. At $15.00 per hour he is earning $225.00 a week ($15.00 x 15 hours) and that increased
times 52 weeks comes to $11,700 per year.
Debt Service: My business enterprise calculator says that if you borrow $40,000 for 5 years (60 months) at 5% and the balance at the end of the 60-month is zero, the monthly payments move to $660.49. Since the formula requires yearly figures we multiply by 12 and get $7,925.92. Most of this payment is principal reduction but we are going to simply deduct all of the payment as is generally accepted in the industry.
Return on Investment: We are going to use the 20% amount we discussed above. Formula one determined that $50,000 was required as an investment which is increased
by 20% (.20) = $10,000 per year return on investment.
Formula #2 (Sellers Discretionary Earnings - Fair Market Wages (For Owner) - Business enterprise obligation Service - Return on Investment (Cash Requirement x Percentage) = Extra Profit/Loss) would-be the look like this:
Seller Discretionary Earnings: $50,000.00
- Fair Market Wages: $11,700.00 (-)
- Business enterprise obligation Service: $ 7,925.00 (-)
- Return on investment: $10,000.00 (-)
= Extra Profit/Loss: $20,375.00
This means that after deducting from the income, wages, funding cost and a return on your cash investment the business still generates $20,375 more profit. Now would-be you buy this business under these circumstances? It would-be appear, yes! Of course this is based on a few assumptions, which strength
not be true. Lets look at them again.
The owner is only working 15 hours a week or he is only doing 15 hours of real activity even as although he is sitting about all day. The else assumption is that a 20% return on your investment is a comfortable return for the risk.
We can likewise consider that if the new owner puts in an extra 25 hours a week doing productive sales the business should be able to afford to pay him another $20,375 for the 1st year. It would-be appear that if the sales activity was done then the profit should greatly increase in the second year or peradventure even as the second month.
Conclusion:
This is a tool to help you analyze a business. It is not the end-all of a business appraisal or evaluation. Simply a tool to help increase your understanding of a business’s value that you may be seeking to purchase. Have fun with it.
Simply simply about the author:
Willard Michlin is an Investor, Business Broker, Calif. Real Estate Broker, Accountant, Business enterprise Distress Consultant, Well better-known Public speaker and Administrative/Business Consultant. He can be contacted at his Ventura, Calif. office by job 805-529-9854 or by e-mail at kismetrei@earthlink.net. See else article by Willard at http://www.kismetbusinessbrokers.com
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