There are many advantages to purchasing an existing business that has a proven history with records of a positive cash flow, as opposed to starting one from scratch that inherently has several unknowns and a high level of risk.
One of the first things you need to do before purchasing another business is to iron out all the details on exactly the type of business you want. If you are shopping for any type of business that may look profitable, try to find something with a simple business model in an industry you are interested in and already familiar with.
You should already have determined the size of the business you are interested in purchasing. With a large business, there could be a higher profit potential, but a large business can also mean more complications, extra employees, added stress, and long hours spent working.
Steps to take when you find a business you want to purchase
So you have finally found the business you want to purchase, and now you need to see a list of financial documents to help you decide if this is the business right for you, and if it is profitable and will remain profitable, and what a good purchase price would be for you. You’ll want three years’ worth of these statements, and you’ll need the owner to go over them with you, explaining the details and clearing up any confusion you might have in fully understanding them. Of course, you should have your accountant with you.
List of documents needed:
- Accounts payable
- Accounts receivable
- Balance sheets
- Cash flow statements
- Credit report
- General ledger
- Gross profits
- Income statements
- Inventory (equipment, products, real estate
- List of debts and liabilities
- Rate of return
- Tax returns
When you find an existing business you might want to purchase, you need to sit down with the owner, your accountant, and your financial checklist so you can avoid making an unwise purchasing decision. This is called ‘due diligence’, and it refers to the steps taken by the buyer, and sometimes the seller, to verify that the information you have received about the business is accurate and correct.
One of the most important pieces of information you’ll get from the financial documents is the value of the business, and there are several ways to determine the value of the business you want to purchase. Some are listed below:
Asset-Based Valuation
– Determine the assets (property, building, equipment, inventory, patents and copyrights), and then subtract the liabilities (loans, bonds payable).
Capitalization of Earnings
– This method uses price-to-earnings (P/E) ratio and net annual earnings to determine valuation.
Discounted Cash-Flow Analysis
– This method uses future business cash flow and cost of capital to determine valuation.
Revenue-Base Valuation
– This figure will help determine annual revenue and purchase price (e.g. 1 or 2 × annual revenue).
Value-Based Analysis
– This method examines the value of similar businesses in the same area and industry that have recently sold. This is very similar to buying a house and comparing it to similar comps (comparables) in the neighborhood.
Your overall checklist should also cover documents regarding legal issues, consumer information, products, employees, and any other relevant information regarding the business. All of this information will help you avoid potential problems in the future, determine if you believe the business will be profitable for you, and assist you in negotiating a purchase price. Don’t do this alone; you’ll need help and your accountant will be helpful.
Other issues to consider when buying a business
If you don’t have experience in the industry, negotiate to have the owner, or someone equally as capable, remain in the business with you long enough to training you or someone who plans to work for you or someone already in the company that wants to stay with the company after you purchase it.
Now it’s time to secure funding and draw up the sales agreement. With the help of your financial checklist, you are now armed with the information to help you by a healthy company at a reasonable price.