Napers asks:

I am looking at buying a small restaurant in my town.  They are asking around $350,000 but there is only about $200,000 worth of assets and nets about $50,000 in income.  How can I determine if it is worth the asking price.  Is there anything else I should consider?

Mr. BizPlan answers:

Lets break this question down into its parts:

Preparing to Buy a Business

At a minimum you should get two to three years of historical income statements (more if they are available).  These will help you identify any trends that are occurring in the business and give you an idea of the potential profitability.  Understand that most small business owners try to minimize their tax liability so there may be some expenses that aren’t exactly necessary or business related.  Another common occurrence is sales that never hit the books (called skimming - it is also called tax fraud - but hey, it happens all the time).  Taking these into consideration you should be able to build projections based on reasonable assumptions.  If the seller says that he takes $1000.00 out of the tills a week add back $800.00 and then make sure you adjust for the taxes they should have been paying.

Another financial statement that you will need is a current balance sheet.  From this you can identify the assets owned by the business.  Typically only fixed assets and inventory are sold in a transaction.  Cash and accounts receivable are left to the seller.  NEVER (if at all possible) assume any of the businesses liabilities.  This includes accounts payable, notes payable and other business debt.  Make a clean break on the sale date and let the seller pay off their debts with the cash you just forked over.

Finally, get an itemized list of assets included in the sale and write them into your offer.  Usually, anything that isn’t screwed down has a habit of walking away the day before the sale.  Put it in writing so that there are no surprises. 

Valuing the Company

Brokers, Sellers and Investors use a myriad of ways to value companies.  The most common form is multipliers.  For example 5X EBITDA (read Five Times EBITDA) is ”Earning Before Interest Taxes Depreciation and Amortization multiplied by a factor of five.”  Assuming your “net” is equal to EBITDA then the value would be $50,000 X 5 = $250,000.  Another is 1/2 of annual revenues plus inventory on hand at the time of sale.

In the accountant world we generally see various forms of two main calculations; discounted cash flows (aka “Capitalization Approach” or “Net Present Value”) and Excess Earnings (aka “Value of Assets + Intangibles”). 

In the discounted cash flows calculation we determine the cash flow for the next year and divide it by the buyers required rate of return (usually between 15% and 35%) minus the annual constant growth rate.  So, as a basic raw calculation if a company you are looking at buying has cash flow of $50,000, you require a 25% return  and the company is growing at 5% annually the calculation would be $50000/(.25-.05) = $250,000.  Obviously this is an extremely simplified example but hopefully you get the idea.  The difference between the value you just calculated and the fair value of the tangible assets is called “good will” or “blue sky”.

For the “Excess Earnings” calculation it is a little more complex.  Basically you calculate the value of the good will (the intangibles) and add it to the fair value of the tangible assets.  To calculate the value of the good will we look at what the average return on assets (ROA) is for a similar sized firm in the industry.  You can find the average ratio by looking in an RMA (Robert Morris and Associates) book.  If the company has an ROA higher than the industry average you multiply the difference (or “excess earnings”) by a subjective multiplier between 1-5.  So for the same example above if the company has $200,000 in fixed assets their ROA would be 25% (50,000/200,000 = 25%).  If the industry average is 10% or $20,000 then the excess earning is $50,000-$20,000 = $30,000.  Multiply the excess earning by the multiplier, say 3X, you get 30,000 X 3 = $90,000.  Add that $90,000 to the value of the tangible assets and you get a value of $200,000+$90,000 = $290,000.

From the two calculations we can see that the value is probably somewhere on the lower side of the $250,000 to $290,000 range.  Usually, excess earning produces a fairer result with asset heave companies.  Discounted cash flows and income multipliers work better with asset light companies.

I hope this information helps.

Mr. BizPlan
www.diybizplan.com