This article first appeared in Personal Finance Magazine, 4th quarter 2017
If you are faced with the opportunity to buy an already established business, there are many things that you need to consider, and questions that need asking, before you sign on the dotted line.
This is the view of Mary-Anne Greisdorfer, an associate director in the audit division of BDO Cape Town, who says that, among many things, you must think about liability, the valuation of the business and your exit strategy.
Before you even consider buying a business or going into an existing partnership, here are some basic questions to ask:
1. Have you analysed the financial records?
Greisdorfer says you should analyse the financial records for the past three years, including balance sheets, profit-and-loss statements, tax returns, purchases and sales records, and bank statements. Also check that these records been well kept and whether the business shows potential for growth.
“The financials form the basis of everything, and your assessment of these is the first point of business, as you want to ascertain the viability and profitability of a business before proceeding.
“Being able to review a fully audited set of financial statements is first prize,” Greisdorfer says. “Second to this, if audited financials are not available, is a compilation of the financial statements. You must also ascertain who did the audit or who put together the compilation – ensure it is a reputable firm with a strong track record. Also be sure to ascertain what accounting framework they used.”
2. Have you assessed the tax implications?
“You’re buying an asset and, at some point in the future, you may wish to sell it, so make sure you are aware of the relevant provisions of capital gains tax law,” Greisdorfer says. “Also, there may be securities transfer tax implications if you acquire business assets in the form of buildings or if you buy the shares in the business, so make sure you have considered these.”
3. Why is the seller really getting out?
“Take the time to ask the seller about why he or she is selling. Build a relationship with the seller and be thorough in your due diligence,” Greisdorfer says.
4. Who is currently steering the ship?
Like a ship’s captain, a company’s chief executive officer or management team steers, rights and can sometimes sink the ship, so it’s important to know who the company’s management is before you buy.
“Ask things like: is the company’s success heavily tied to this person/these people? Do you feel comfortable that the business can still do well if those people leave the company?” Greisdorfer says.
5. What business model does the company use?
What business model/strategy does the business use to maximise its profits? For example, does it offer the lowest possible price so it can sell more products, or does it sell fewer, higher-quality items but earns a larger profit per product sold?
6. Does it have a competitive advantage?
Do the business have a competitive advantage over other operators in the same line of business, through superior products, patents, brand power, technology, customer service or operating efficiency? “Ask what is unique about this business’s product or service,” Greisdorfer says.
7. How does the business “make its phone ring”?
“Any business needs to have a growing customer base to be successful,” Greisdorfer says. “So it is important to know what marketing the business has engaged in and what was successful versus what was not. Also, find out whether the product or service the business offers is likely to maintain or improve its marketability, or is it in danger of becoming over-sold, out of style or obsolete?
“Also, do some market research and see what the public perception is of the business – don’t just take the word of the seller.”
8. Is revenue rising?
Revenue is simply the amount of money the business made from the sales of its product or services. “While it’s not realistic to expect a company to increase its sales every single year, especially in a struggling economy, a company with a trend of falling annual revenues signals that it has troubles.”
Greisdorfer advises that you try to ascertain what the sales patterns are year by year and month by month, and if there is a seasonal pattern or one related to a business cycle.
9. Are the profits increasing?
While revenue may be increasing, profits may not be. Profit, or net income, is the amount of money a company earns from sales after expenses and taxes have been paid.
“A company with growing profit each year shows that the business is successful, but have you considered the effect of inflation on sales and costs in the years to come?” Greisdorfer says.
“Also look at year-on-year trends in expenditure, and ascertain things such as whether the business has been cutting costs to boost profits. Are there maybe unrecorded liabilities that would understate the expenses to boost profits? Is the business carrying more stock at year end, as this reduces the cost of sales numbers and increases the profit numbers.”
10. How much debt does the business have?
“It is important to do a debt-to-equity ratio analysis, which will help you to ascertain how much debt the company carries compared with the amount of equity held in the business. This indicates how well the business can repay its debts should it run into serious financial problems. Generally, the lower the debt-to-equity ratio a company has, the less risky it is to you as a buyer.”
11. What are the turn-around times on sales and on payments to suppliers
“Another important factor is to assess if the business carries high volumes of stock, and what the turn-around time is between stock being sold and the suppliers being paid. There may possibly be a cost or financing element for you regarding when they need to pay the suppliers. You may need to have spare funds available or get financing to cover the period between suppliers being paid and money from debtors coming in,” Greisdorfer says.
12. Are you savvy about the legalities?
Greisdorfer says it is important to ask questions such as what are the terms and conditions of any applicable lease agreements and your obligations and rights under such agreements? Are there any legal proceedings pending against the business or the seller? Have you sought legal and accounting advice on the best way to handle your finances, the purchase and your business structure?
13. What is your exit strategy?
“This is an important question to ask even as you make the decision about whether to buy a business or not,” says Greisdorfer. “This should be considered right from the start. You should also have a buy-sell agreement in place if you happen to have any partners involved in the business.”
Other things to consider
“There are so many other things that should be assessed before committing to buying a business,” says Greisdorfer. “Such as, how old the machinery is (if applicable) and if it will need replacing any time soon and at what cost? How much stock needs to be carried to meet demand? Are you satisfied that the expenses disclosed include all expenses incurred by the business? Has the seller covered the business with the necessary insurance cover? Have all compliance requirements (work, health and safety, quality assurance and environmental compliance) been met and do they appear in the accounts? Are any goods on warranty? If so, should you make a financial allowance for possible warranty commitments? The list can almost be endless, and that is why it is important to consult a financial expert who can guide you through the process."
- PERSONAL FINANCE ONLINE