When buying a business, there are many things you look for to make it a fit for you. You want it to be something of which you are interested and that you will enjoy, as well as profitable. While most people have no problem knowing what they want, they sometimes get excited and overlook red flags they should address in their decision to buy. Although some red flags can be simple to correct, many are not and should be a signal to walk away.
If you are buying a for-profit business, it should be showing a profit. The financial statements and income tax returns should mirror each other; and, if they don’t, that is a huge red flag. Sometimes the bookkeeper of the business, which may be the owner of a small business, prepares a quarterly P & L (Profit and Loss Statement) and hires an accountant to prepare the income tax returns at the end of the fiscal year. There is some good accounting software that is easy to follow and from which to print P & Ls. However, most businesses prefer to have a CPA prepare their P & L Statements quarterly and their income tax at the end of the fiscal year.
There are expenses a business owner can legally deduct through the business. These will be shown on the P & Ls and the tax returns and are an advantage as they show less profit and a lower amount of taxes. When a business broker is evaluating a business these will be added back, showing more profit, which is the actual amount made. Items added back are 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. The business owner must have receipts and proof of the expenses, so a buyer will want to ask to see this proof. If you are the buyer and the owner does not have proof of these expenses, that is a red flag. You will want to make sure the expenses with no receipts are not added back in the adjusted cash flow statement. Without proof, you will have to assume those will be real expenses in the business after you buy it. If a business has hired a CPA to prepare profit and loss statements and income tax returns, you will have less chance of finding red flags. Also, if a professional business broker has valued a business and prepared an adjusted cash flow statement, there is less chance of finding red flags. Don’t ever just assume everything is accurate. Ask for proof.
We have covered financials pretty thoroughly, as you want to make sure the numbers are correct. However there are some other red flags, one of which is being in business only a short time. There are some legitimate reasons business owners need to sell after a short period, but it is difficult to justify an asking price based on the limited financials. If the business has been owned for less than a year or actually in most cases for less than three years, it is difficult to show a good profit. If there is no profit or a small profit, you are actually just buying the assets of the business. It could still be a good buy, depending on the growth of sales and the circumstances of the owner having to sell. You would want to make some projections of sales and profits for the future, but you would not pay for future projections, only for the assets.
When you purchase a business, the inventory is included in the purchase price. That factor can change up or down after the final inventory is counted just before closing. The red flag for inventory is long before that point. Sometimes owners carry an inventory that is too large and have too much money invested in it. Also, make sure you are not purchasing old inventory that will never sell. Your proximity to the suppliers and the length of time required to transport are two important factors. Also, a business that is not clean and is cluttered may have lots of things that need to be thrown out and not purchased by you, the buyer. Be sure to look at the equipment to determine if it is working and how much longer it will likely work before needing to be replaced.
Look carefully at everything in a business you are thinking of buying. You will find the perfect one to fit your needs!
