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.
If you would like to discuss business valuation, contact the SCORE Association (Service
Corps of Retired Executives.) SCORE offers free and confidential small business counseling
and mentoring as a community service. More than 12,000 working and retired business
owners, executives and managers donate their time to assist entrepreneurs.
Call 1 (800) 634-0245 for a referral to the SCORE chapter nearest you.
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