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Caveat Emptor

April 29th, 2008 by Chris St Cartmail

Buying a business is not like buying a car. Get it wrong with a business and it is likely to seriously hurt your wallet. So how can you tell if you are looking at one where the wheels might fall off? Nick Pritchard from Transaxman ltd has helped us put together a few examples of what to look out for and how to assess the true profitability of a businesses. Remember that the seller knows a lot more about the business than the buyer.

There are a number of indications that a business is in difficulties. Such as reduced recruitment and training activity, delay of planned maintenance, missing a major trade show, closure of product or quality development teams and reduced investment in tooling or software. When companies are prepared for sale, if the business is in some difficulty, they may simply cease any forward expenditure or investment. Continued investment in a business is essential in ensuring growing profits. This is often the reason that the best businesses to buy are the ones that are not actually being marketed for sale.

So you have seen a great business and you are doing due diligence. Don’t let the vendor pull the wool over your eyes! There was one well documented fraud where everything seemed hunky dory, but the vendors had hired in a number of temporary staff to make the factory look busier while the potential buyers were looking around.

Arriving at the adjusted net profit

There are essentially two main types of adjustments that need to be made:

* Allowances for non-recurring items, such as a grant or a big debt
* Items shown as costs that are really a distribution to the current owners.

For example, distributions to owners might be special pension contributions, or expenses that are a consequence of the life style of the shareholders, as well as the usual salaries and benefits in kind. In one instance a US business was in the process of buying a company in South Wales, unfortunately the vendor had forgotten that he had put his Cardiff Arms Park debenture through the company – Once the purchaser understood the importance of being able to take customers to the match, the vendor had to buy his own tickets.

Where a company occupies its own freehold property it may also be necessary to adjust the trading results for a notional rent charge, if the property is worth substantially more than its book value.

Standardising earnings
The purpose of restating results is to show what the earnings of the business would have been on a standardised basis, as a guide to the future earnings. The valuation exercise is done therefore to establish how much a theoretical buyer would be prepared to pay as a capital sum in exchange for the right to receive those future earnings.

Earnings for this purpose would be trading profits before interest but after a notional taxation charge. This recognises that the value of the business may be different from the value of the equity, as the latter value will depend on how the business has been financed. Where businesses have accumulated cash reserves it should be remembered that these funds represent past earnings which have not been distributed.

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