So you’ve found the business of your dreams and it’s for sale. Before you go ahead and make an offer to purchase, it is critical you understand (and trust) the numbers.

The vendor will be motivated to maximise the value of the business and present it in the most favourable way possible and therefore it is important to identify their motivations for selling, as well the risks and the outlook for the business.

Doing your homework (ie comprehensive due diligence) will enable you to make an informed decision and minimise the risk of over-paying. This article is designed to cover off some of the basics.

Don’t confuse the top line and bottom line

The distinction between revenue (ie what your customers pay you) and profit (ie what is left after paying all your outgoings) can confuse prospective buyers. Generating profit is what ultimately matters;even if your target business looks promising based on its sales or cash takings (eg. revenue), the business may be loss making (eg. after tax).

Understanding the nature of revenue and cost line items (and whether they are recurring) is also important. One-off items such as an insurance payout can prop up profit, or if staff are not being paid a legal wage and therefore the financials may not accurately reflect the earning potential of the business

Beware of creative accounting

There are many tricks and traps to be aware of when reviewing accounting records, particularly if the financials are not audited.

For example, a business may recognise revenue they have not yet earned or capitalise costs thereby recording them as an asset when they are actually an expense. Without reviewing the full picture (profit and loss, balance sheet and cash flow), it is easy to be misled regarding the performance of a business.

Know what you are buying

The financials may include assets and liabilities (for example a leased asset) that are not being included as part of the sales process and therefore a buyer must identify these and determine what impact these items may have on future profitability.

Similarly, you may be required to procure additional assets (ie purchase or rent a business premises, plant and equipment etc) or refurbish assets.The buyer should allow for additional expenditure over and above those presented by the vendor.

Commerciality of related party dealings

It is important to consider if all transactions recorded in the prospective business are on commercial terms or if they need to be restated.

For example:

• do labour costs accurately reflect the personnel required to operate the business? eg. consider related party employees (family members or friends) whose remuneration recorded in the books and records may not be representative of the time spent working in the business
• receiving products or services from a related party for little or no benefit that will not continue if you were to take buy the business
• owner salaries may not be included in the accounts, or be at a level lower than your required return for time and effort spent running the business.

What is the potential for the business and industry

Benchmarking should be undertaken to compare the business against its peers and industry averages, as this will assist in identifying its strengths, weaknesses and opportunities. Benchmarks examples may include:

• comparison products or services
• assessment of relative market position (usually based on revenue)
• comparison of fee structure.

Potential purchasers should request any relevant benchmarking analysis maintained by the vendor, or the franchisor, during the due diligence process.

A review of historical performance (typically three or more years) can help to identify trends and gauge potential as you may find:

• declining profit margins: possible inability to pass on cost increases onto customers
• declining sales: may indicate product obsolescence.

Do your due diligence

Due diligence involves a comprehensive investigation of the target business.It is more than an audit, as it is designed to provide comfort to a prospective purchaserthat the seller is accurately representing the business and errors and risk areas are identified.

There are two key categories of due diligence and both are usually required:

·         Financial -investigative rolewhich seeks to validate financial, commercial, operational and strategic assumptions.

• Legal: assessing contractual terms (including identification of onerous clauses, representations and warranties), legal ownership of assets anddebts and identifying any legal actions on foot or pending associated with the vendor personally or the business.

Due diligence findings can often assist greatly when negotiating with the vendor and so despite the costs of undertaking research, it can be a cost saving down the track.

Setting yourself up for success

Finally,our top tips for prospective buyers:

1. Do your homework

Even if you are not a numbers expert,seek to understand the financials as much as possible, make sure you have a deep understanding of the business (ie what it does and its risks), ensure you have the necessary skills,identify your motivations and why the vendor is selling.

2. Get professional advice

When in doubt, seek help. Buying a business is a big decision and investing in professional accounting, legal and valuation advice upfront can save you money in the long run (including helping with negotiations).

You don’t want to find out that the business is a lemon after you have purchased it.