When purchasing a business it is important to understand its value. The value of a business will ultimately determine whether to purchase it and if so, how much to pay. A number of factors need to be considered when determining the value of a business, including; it’s financial position, future forecasts, existing customer relationships, staff structure and relationships, why the current owner is selling, your future exit strategy, and the list goes on.
Ideally, advisors who specialise in completing due diligence and financial analysis should be used. However, if that isn’t possible or if a ‘starting point’ is required before a specialist team is brought in, here are four key areas to focus on:
the reoccurring nature of revenue,
the quality of earnings,
what drives business growth, and
the business’s cash flow.
Understanding business revenue is integral to understanding the value of a business. A key question is therefore how is revenue secured going forward, i.e. how does the company retain their customer base? If business sales are generated by long-term contracts this will greatly increase the value of the business when compared to unsecured business sales that are retained by customer loyalty alone.
Further, if customer loyalty is attached directly to the existing business owner this can decrease the value of the business. Understanding what drives the business revenue provides a more in-depth understanding of the reoccurring nature of the revenue and what a new business owner will need to do to retain the same level of revenue.
Secondly, the quality of earnings must be examined. The earnings you use to value a business should be earnings that are maintainable into the future. Often within company accounts there are entries that distort a business’s true earnings. These can be one-off events that will not occur again in subsequent years such as a large cost or sale that is attributable to unusual circumstances. Staff and rent costs are often worth examining as it is common for these costs to not truly reflect their market price. All costs must be adjusted to market value to provide a fair reflection of profit.
Often, earnings will be forecast to grow into the future. If this is the case understanding what drives that growth is paramount. In order to analyse this it is useful to compare the historic accounts with the forecast accounts and analyse the key assumptions and key risks to achieve the growth. Assumptions should be realistic and the risks shouldn’t be understated.
Finally, the working capital requirements of a business should be examined. Every business has different cash flow requirements due to seasonal changes or supplier and customer relationships. Can future capital requirements be funded? Moreover, if the business is forecast to grow, what working capital is required to fund that growth?
Answers to the above questions will help determine whether the business is worth purchasing and might save some money when negotiating the price with the vendor.