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Checklist: Evaluating the purchase of a business

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Last updated on December 18, 2012
A successful evaluation should indicate the potential of the business and enable sales, profit and cash flow projections to be made for at least the next 12 months.

It may be tempting to act quickly so that you don’t miss out on what you think is a good opportunity.

It’s worth taking the time and putting in the effort to ensure you make the right decision.

Seek the advice of professional advisers who will help you as you evaluate the following aspects of the business under consideration:

Reasons for selling

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  • Find out as early as possible why the current owner has the business on the market and how highly motivated they are to sell - this will help you establish how much scope you have to negotiate price and terms.
  • Obtain good information by asking a series of well-structured questions - if you feel you’re not getting straight answers, try asking the questions in another way.

Profit

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  • Look at the performance of the business over time and determine why the business is making a profit or loss - exercise caution if a good profit is only a recent occurrence.
  • Consider the trends apparent in the gross profit margin and compare this with the industry norm - a decline may indicate anything from incorrect stock figures to heavily discounted prices to a high level of pilfering.
  • Calculate the net profit margin on sales and identify the reasons for any trend in net profit - it may be that sales are lower or expenses higher.
  • Assess whether profits are enough to take the risk - remember that a business can only be truly assessed on figures that can be verified, so ignore ‘black money’ or undeclared income which the vendor may claim is regularly taken out of the business.

Sales

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  • Obtain a detailed breakdown of sales and assess:
    • the sales trend
    • whether the product or service is likely to maintain or improve its marketability or if it’s in danger of becoming over-sold or obsolete
    • where sales are in relation to inflation
    • what is selling and what is not selling
    • the conversion rate of inquiry to sales orders
    • who is buying the product or service.

  • Verify figures by:
    • inspecting invoices and statements from suppliers
    • inspecting daily cash books, bank statements and income tax assessments
    • asking employees how many customers they service daily and details about the average sale
    • asking neighbouring businesses how busy the operation is
    • surveying numbers of customers patronising the business over a period of time.

  • Consider the stock of the business and determine:
    • the trend in stock levels relative to sales
    • the amount of stock normally carried in relation to turnover of the business
    • the number of stock turns achieved in a year
    • whether stock figures are accurate and not inflated – old slow-selling stock for which invoices are ‘hard to find’ can often be included in the stock figure at inflated prices
    • whether goods have been supplied with warranty – if so, you’ll need to make allowance for possible warranty commitments.

Expenses

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  • Investigate all aspects of expenditure, including whether:
    • there is a trend in expenses
    • private expenses of the vendor have been shown as business expenses – the areas of most frequent abuse are telephone, wages, motor vehicle, advertising and insurance
    • advertising costs are in proportion to business turnover
    • there is a balance of expenditure on light and power relative to sales
    • repairs and maintenance contain any one-off expenditures – a high level of repairs and maintenance could mean the business has a large amount of old or unreliable equipment
    • salary drawn by the vendor has been included in wages
    • drawings by the vendor have been variable or irregular
    • there are any additional expenses that would have to be incurred under your ownership
    • the vendor has received any unpaid assistance while operating the business – if so, you’ll need to make allowance for this in your financial projections.

Assets of the business

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Stock

  • Organise an independent stock count with attention to:
    • age
    • quality
    • saleability
    • style
    • condition
    • balance
    • suitability
    • freshness.

  • Establish whether any goods are on consignment, with the right of being returned for full credit.

Building, furniture, fixtures and equipment
  • Wherever necessary and appropriate, arrange independent appraisal, assessment and verification as you determine:
    • the market value of the building, furniture, fixtures and equipment
    • how useful, modern, efficient and usable they are
    • whether all local council and health regulations are satisfied
    • how much the vendor has spent on keeping the facilities in good condition
    • whether there is any money owing under hire purchase or lease agreements
    • if any assets are located elsewhere and, if so, whether they are subject to a lien
    • whether the depreciation policy has been realistic.

Accounts receivable/debtors

  • You have no obligation to take over outstanding debtors – if you decide to do so, ensure that customer lists, business and credit records and mailing lists are included in the contract of sale.
  • Make an assessment of your prospects for collecting on outstanding accounts based on the quality of debtors and the prevailing economic climate.
  • Assess the success of the vendor in past collections – determine the average collection period from financial statements.
  • Check the volume of business coming from credit customers with slow payment records and consider the implications for working capital.
Supplier and credit relations
  • Assess whether supply sources are satisfactory and whether they are likely to continue on favourable terms – if not, check whether the business is committed to them by contracts.
  • If future deliveries are scheduled, determine whether they should be increased or cancelled.
  • Assess how the business would be affected if key personnel were lost.
  • Consider whether existing employees will be an asset or liability to you as the new owner.
  • If you are considering any changes, be alert to potential liabilities for redundancy payouts.
  • Assess the reputation of the business and whether it has an established, satisfied clientele – you’ll need to allow for a probable loss of a certain percentage of clients when preparing budgetary projections.
  • Determine whether any contracts that are in place with key customers are transferable to you.
  • Establish whether the contract of sale prevents the vendor from re-entering business in competition with you – have the contract checked by your legal adviser.
Trademarks, patents, copyrights and other intellectual property
  • Determine whether they are included in the contract, whether they are transferable, and whether they will be as valuable in the future – seek the help of your professional advisers as required.

Franchises

  • Contact the franchisor to find out whether an exclusive franchise is transferable to you and any transfer requirements.
  • Assess the terms of the franchise, how long it has to run and its value to you.

Lease

  • Seek the advice of your professional advisers before signing any lease and make sure that:
    • it is transferable to you
    • the terms enable you to undertake the activities needed to operate your business
    • it is included in the contract of sale so that the legal obligation to purchase depends on availability of the lease

Liabilities

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  • Seek the advice of your professional advisers as you investigate the liabilities of the business.
  • Liabilities may be extensive and range from unpaid bills to back taxes to superannuation commitments and redundancy payments.
  • The contract should include details of any liabilities you agree to take over, as well as a clause to say that all claims not shown and revealed in writing at the date of purchase will be the responsibility of the vendor.

Taxation and Finance

  • Check all taxation matters concerning the business, paying particular attention to whether:
    • there are any current disputes with the Australian Tax Office
    • PAYE, BAS, superannuation and other tax payments are up to date
    • the market value of plant and equipment is different from its written down value
    • the business has significant goodwill
    • there are any accrued holiday pay, long service leave entitlements or retirement payments to be made
    • any of the vendor’s book debts are likely to become bad
    • any repairs need to be done
    • you’ll need to borrow to finance the purchase.

Other factors

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  • Determine the past and future trends of the business, industry and neighbourhood community.
  • Explore the history of the location and establish the type of businesses that have operated there as well as their level of success.
  • Consider what the total capital requirement will be – it must be adequate to cover working capital, repairs, modernisation, new equipment, new stock, debtors, reserves for taxes, insurance, opening expenses, legal feeds, stamp duty plus, say, 10 per cent for unexpected expenses.
  • Assess the total capital investment in relation to profitability.
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