The warning signs to look out for when buying a business

The warning signs to look out for when buying a business

If you’re thinking of buying a business, you probably have a fair idea of the type of business you’re looking for.

The ideal business for you will be one you will enjoy working in, in an industry that you have experience in or that interests you, and of course… one that is profitable.

However, once you find a business that is attractive to you, it’s very easy to become caught up in the excitement of buying it, ignoring the warning signs that indicate the business might not be as profitable as it appears to be.

So how do you tell if the profit is real?

And what are the other warning signs to look out for when you’re thinking of buying a business?

Do the numbers stack up?

Do the numbers stack up?

If you are buying a for-profit business, it obviously should be showing a profit.

However, if the financial statements and income tax returns don’t mirror each other, this is a big warning sign.

Take a look at the quarterly P&L (Profit and Loss) Statements, which are usually prepared by the bookkeeper or the owner of the business, alongside the tax returns.

Note that there is probably less chance of finding warning signs if a business uses professionals to prepare Profit and Loss statements or an adjusted cash flow statement.

Regardless of who prepares the numbers, do they stack up? If not, get your accountant or financial advisor to take a closer look at the financial statements and income tax returns to see where any discrepancy lies.

Never assume everything is accurate… and always ask for proof.

What expenses are included in the adjusted cash flow statement?

What expenses are included in the adjusted cash flow statement?

Firstly, look at the expenses a business owner can legally deduct through the business. These will be listed on the P&L and they include one-time expenses, owner’s personal expenses, expenses not necessary for the operation of the business, and depreciation, which is not a real expense and has the only purpose of causing the owner to pay lower taxes.

These expenses are both a tax deduction and an advantage because they allow the business to show a lower profit and therefore pay less tax.

When calculating the profit of a business, you will need to add these back to see the actual amount made.

If the business owner does not have proof of these adjustments, that is a warning sign and you’ll need to assume those will be real expenses in the business after you buy it.

Are there 'undeclared' cash benefits?

Are there 'undeclared' cash benefits?

Another really big warning sign is undeclared cash benefits.

If a seller mentions that there are lots of cash benefits in a business (i.e. undeclared income or expenses and personal benefits) that they can’t substantiate and aren’t ‘through the books’, these should not be included in the business valuation and you might want to undertake further due diligence before proceeding with the business purchase.

These cash benefits are likely to be illegal and therefore something that a new owner probably won’t continue to benefit from.

And it’s totally unreasonable for the seller to have enjoyed that perk while operating the business and then expect to see the value of that taken into account when selling.

It’s bit like having your cake and eating it too… and banks won’t have a bean of it either, when you’re trying to secure financing.

What is the inventory really worth?

What is the inventory really worth?

When you purchase a business, the inventory is part of the valuation and depending on the nature of that business it can fluctuate up and down until the deal is closed. But what the inventory is really worth to you depends on a couple of factors.

Firstly, how much inventory is there? Is the seller carrying an inventory that is too large and if so, do they have too much capital tied up in it?

What is the age of the inventory? Are you purchasing old inventory that will never sell?

Are the suppliers close to the premises and what is the length of time required to transport inventory?

Is the business dirty and cluttered? If so, items listed on the inventory may well need to be thrown out instead of purchased by you.

You also need to ensure that all of the equipment is working properly and assess how soon it might need to be replaced or upgraded… or even if it will be superseded by new technologies at some stage in the future.

How long has the business been with the current owner?

How long has the business been with the current owner?

While there are some legitimate reasons why business owners need to sell after a short period, selling a business after owning it for a short period of time can be another warning sign.

It is always hard to estimate the worth of the business based on limited financials. In fact, if the business has been owned for less than three years, it is difficult to show an accurate profit trend.

With no profit (or even a small profit) you are really just buying the assets of the business – though it could still be a good buy if you can secure it for the right price.

In this situation you need to really understand the reasons for the business sale and take a close look at sales turnover. And while you’ll want to make some projections of sales and profits for the future, you would not pay for future projections, only for secured contracts.

Don’t ignore the warning signs!

If you look carefully at everything in a business you are thinking of buying, you’re sure to find the perfect business for yourself.

Although some warning signs can be simple to correct, many are not and should be a signal to walk away.

If you need help with buying a business, contact us to find out more.