Before you buy a small business determine its worth. This is a crucial business activity. If you purchase a business that is overvalued, you paid more money than the business was worth. If you purchase a business that is undervalued, you may have saved money up front, but is the business weak? Value is important; you want to look at assets, accounts receivable, sales and balance sheets. Do not value intangible assets such as goodwill and reputation, while important you do not want to pay cash for such items. The valuation of the business should also be agreed upon by the seller and potential buyer or further negotiations are pointless.

There are two basic methods of evaluating a business: the appraised value of the assets at the time of negotiation and future expectations of profits and return on investment. Appraisal of assets is the more common method of setting the value of a business. The present value of the business is based solely on the value of its current assets. This method is probably used so often because it is the simpler and more tangible method.

Since valuation of assets is more common, here is a bit more information about those assets, which are being valued. As an asset the value of inventory carried on the books for merchandise is the price paid rather than the current value. This can lead to assets being dangerously overvalued. Base inventory valuation on current value not purchase price. The total inventory value could be grossly overstated, if the inventory is loaded with items no longer in demand or items whose price has dropped. Establish the actual business inventory and it’s current real value, not original purchase price.

Another area to give special attention is accounts receivable. Examine these accounts carefully to make sure that there are not many overdue accounts, which may be uncollectible. Ask for a report showing the age of receivables, accounts which are not due yet, due now at 30 days, overdue by 30, 45, 60, 90 and 120 days. The older the accounts receivable the less likely the money will ever be collected. If the business has a large number of accounts at 45 days or 60 days, check the payment history of the clients in question. Do those overdue accounts get paid by clients who routinely pay slowly? This is crucial information, money you can’t collect offers no value to the business.

Using future expectations as a valuation tool is risky. This method establishes a value for the business based upon the future expectations of its profits and return on investment. The buyer looking at the business history and projections for the future may opt for obtaining financial statements, business trends and forecasting of the businesses future based upon its past performance. To obtain a clear picture of the business, both the potential buyer and the seller need to consider factors such as trends in sales and profits, the capitalized value of the business and the expected return on inventory. Such projections are not easy, but can begin with the preparation of projected profit and loss statements.

The buyer should always remember that the seller’s own statements are likely to be overly optimistic and even overstated. The buyer must be wary of the business that looks too good to be true. For how long should these statements be projected? One year? Three? The best ways to decide is in terms of the expected return on investment. If it’s estimated that the business should return 20 percent on the investment, then the investment capital should be returned in five years. On this basis, the projected statements should cover five years

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