Sanity-Check--Buying-a-Business by ancih


									Sanity Check - Buying a Business
Author: Willard Michlin
In the business broker community there is a review process that helps a buyer determine if a business purchase makes sense or not.
This check can be done by a Fortune 500 company where everything is figured down to the penny and takes 1000 hours of research or it
can be done by a small main street shop buyer who figures it out in 1 hour. Each item in this review process requires a decision. This
decision can be based on extensive research or just on a reasonable guess.

The beauty of this process is; how long you want to spend on doing this activity is totally up to you. As we review this process, I will
explain the variables of this system so you can make the necessary decisions where needed. Remember, this is only a tool to help you
make decisions about a business purchase; it is not a sure-fire foolproof system. I will just lay it out for you and you make your own
decision as to the validity of this formula for analyzing a business purchase that you may want to make.

The Sanity check requires two mathematical formulas, which require dollar amounts or other numbers to be entered in each formula. The
math is calculated and then the results are compared against the purchase price. If it doesn’t work out the way you wanted, you have
the option of then going back and change some of the numbers and do the calculation a second time.

The two formulas are:

1. SP + WC – BF = CR

Sale Price + Working Capital - Borrowed Funds = Cash Requirement

2. SDE – FMW (FO) – DS - ROI = Extra Profit/Loss

Sellers Discretionary Earnings - Fair Market Wage (for the owner) - Debt Service - Return on Investment (Cash Requirement x Interest
rate -Stated as a Percentage) = Extra Profit/Loss

Since each item in the formula needs to have a dollar amount determined, we will define the terms and then discuss how the dollar
amount is derived at.

Terms Definition:

Sale Price: The price that is being asked for the business or the price the buyer is thinking of offering. Depending on when you do this
analysis. If you are trying to determine an asking price you would calculate all the other numbers in these two formulas to determine what
should be your offering price. We will do examples to make this clear later in this article.

Working Capital: The short-term assets minus the short-term liabilities are the accounting definition. The simple explanation would be
the amount of money necessary to be invested by the buyer to run the daily operations of the business, once purchased. This would
include monies tied up in inventory, and accounts receivables. Money invested to pay the landlord’s or utility company’s
deposits. Also included is the money spent on the business purchase to cover the loan origination costs and purchase escrow fees when
buying the business. It is the total funds invested into the business to keep it running. The down payment given to the seller is not part of
this number, since it is included as a separate item.

Calculation notes:

1. Cost of inventory: $_________________ (+)

2. Accounts receivable: $_________________ (+)

3. Landlord deposit: $_________________ (+)

4. Utility Deposits: $_________________ (+)

5. Escrow fees to purchase: $_________________ (+)

6. Loan origination costs: $_________________ (+)

7. Short term liabilities* $ _________________ (--)

Total Working Capital $_________________

* Short-term liabilities are defined as liabilities that are to be paid off within 1 year – accounts payables and the part of any notes
payable that are to be paid within 1 year.

Borrowed Funds: The loan made for a business purchase from a bank or private party. The private party can be the seller or some friend
or relative who might be willing to make a loan. This is borrowed money that must be paid back to someone at some time in the future.
Cash Requirement: This is the invested cash required to both buy a business, and working capital-to run the business. The amount of
cash needed to make the business purchase and run the operations of the business after deducting all borrowed funds, regardless of

Sellers Discretionary Earnings / Owners Total Benefits: This is the total of all the non-business related benefits going to a business
owner or his family on an annual basis that have been paid for, by the business. Included in this is definition are taxable profit from
operations, unreported cash income, owners salary, salaries to non-working family members, any amount over the fair market value of
salaries paid to working family members, family auto expenses, family telephone, family office expenses, health and life insurance for
any or all family members, pension plan/ profit sharing contributions paid for the benefit of family members. This can also be stated as
the reason why most people go to work everyday; they get family support for working.

Calculation notes:

1. Taxable profit from operation $_________________ (+)

2. Cash $_________________ (+)

3. Owners Salary $_________________ (+)

4. Salaries of non-working family members $_________________ (+)

5. Amount over the fair market value of wages

of working Family members $_________________ (+)

6. Family Auto Expenses $_________________ (+)

7. Family Telephone Expense $_________________ (+)

8. Family Office Expense $_________________ (+)

9. Health and Life insurance of

Any/all family members $_________________ (+)

10. Pension plan/profit share family members $_________________ (+)

Total Seller Discretionary Earnings: $_________________

Return on Investment: We need to have this stated as a dollar amount in Formula two. ROI is calculated as follows:

Cash Requirement X “a Percent†- the greater the risk, the higher the percent

First we must determine what the interest rate return we wish on our investment. This is a very subjective percentage and a change in
this number can change the whole result of this analysis. If it is of any help, many financial investors in “Corporate America†feels
they need to get a 20% return on their invested capital. Companies do not always make money and therefore the possible loses are built
into the ROI. Some of the reasons are: companies are bought and go broke, overseas competitions causing expectations of growth and
income not to be met, and lastly government regulations periodically close whole industries. These are just some of the many risks
involved in owning a business.

Putting your money in a bank has little risk, because the Federal Government insures your deposits in the bank. The stock market has a
lot of risk that many people do not fully understand, causing them to accept a long term ROI of 10-13% from mutual fund investments. A
95% drop in stock prices like the stocks or what happened when we had the oil embargo in 1992 are indications that the stock
market can be a much higher risk than people realize.

I personally feel that owning your own business and buying real estate are much lower risks, providing a much higher return. The proof of
this can be found in the number of people who got rich in real estate and the over 25 million small business owners across this country.

Figure out what ROI you want and insert this number as .20 amount to represent 20% or .06 to represent 6% ROI. This is an annual
return on invested money.

Once you have a percentage return on your investment we need to multiply it by the Cash requirement in order to come up with a dollar
amount return needed. This restated is Dollars invested x percentage (stated as a decimal) = Dollar return on investment.


1) Investment of $50,000.00 @ 6% Return on Investment (ROI) would be calculated as follows: $50,000.00 X .06 = $3,000.000 (Dollars
return on investment)

2) Investment of $50,000.00 @ 20% Return on Investment (ROI) would be calculated as follows: $50,000.00 X .20 = $10,000.00 (Dollars
return on investment)

Debt Service: The reason we need this number is because this is a financial expense of owning a business. It is not an operating
expense of the daily business operations but if you have debt, in your business, you must be able to make the payments, out of the
business operations profit. Usually this payment is mostly interest and a smaller portion is the principal reduction of the loan balance.

Most professionals deduct the whole payment when doing this analysis, because the business must generate enough profit to make the
whole payment. My personal preference is to just deduct the interest portion and to add the principal portion of the payment to working
capital amount needed. This counts as more money being put into the business just like financing inventory and/or accounts receivables.

For simple one-hour analyses it is not worth splitting up the payment. In the case of a very large principal reduction payment it could be
unreasonable to not split it up. It is up to you. Y can always try it both ways, since this is a process to raise your understanding, not to
come up with a fixed answer of, yes! It is a buy or no! It is not a buy.

Fair Market Wages: This is an amount that the new or old owner would be paid, if he were an employee not the owner. If the owner were
the company salesman and also the company bookkeeper working a total 60 hours a week, a reasonable salary would have to be
determined for each job. As an example only, let’s say that an outside salesman, in your industry, could make $40,000 per year. And
a bookkeeper usually charges $15 per hour. The salesman might very well work 50 hours at this job to earn this salary. If a bookkeeper
would work 10 hours per week doing the bookkeeping that would mean 520 hours per year (10 hours x 52) times $15.00 per hour which
comes to $7800 per year for the bookkeeper. The two Fair Market Salaries would come to $47,800 ($40,000 + $7,800).

Sometimes the market salaries are not so easy to figure. Let’s take an owner who owns a 99-cent discount type store. This
shopkeeper works 70 hours per week behind a counter in the store. Y can hire a counter person for $7.00 per hour so this becomes
(70 hrs x $7.00 per hour x 52 weeks).

Then you start discussing that this $7.00 per hour counter person would not be able to do the buying. Y might want to figure a
purchasing agent's salary. This can be done or you can just do simple numbers, leaving the salary only based on a counter person’s


By now you have the information to come up with numbers to put into the formula. Let us create a scenario. This was a transmission
shop. The customers pay COD-upon pick up of the car. The parts inventory is from old transmissions and show on the books as worth
nothing. The seller-owner is asking $75,000 for this business that he is able to takes out $50,000 in profit or benefits. In an interview, the
owner mentioned that if a buyer will put $40,000 as a down payment he would carry the $35,000 balance at 5% interest for 5 years. By
observation, we can see that the current owner sits in the office and does the bookkeeping, orders parts and makes bank deposits. He
has a manager who bids jobs and handles production. No one is going out and calling on prospective business, which is one thing the
owner should be doing with his time, but he is not doing. Let’s go through what the numbers are with this example.

Math Formula #1: Sale Price + Working Capital - Borrowed Funds = Cash Requirement

Sales Price: $75,000

Working Capital: The business requires $10,000 cash infusion upon close of escrow, mostly to pay the landlords deposits and start a
new marketing campaign.

Borrowed Funds: $35,000

So, the calculation for formula #1 looks like this:

Sales Price: $75,000

Working Capital (+) $10,000

Borrowed Funds (-) $35,000

=Cash Requirement: $50,000.00

Math Formula #2: Sellers Discretionary Earnings - Fair Market Wages For Owner - Debt Service - Return on Investment (Cash
Requirement x Percentage) = Extra Profit/Loss

Seller Discretionary Earnings in this case is, let us say, $50,000.00.

Fair Market Wage: Y can calculate what you consider fair or you can put all of the other numbers into the equation and see what is left
for salary. If you like the salary you buy the business, if not you do not. If we were to calculate what the owner’s salary should be I
would not pay much for what he does. Even though he puts in 50 hours a week he really only works 15 hours a week of true production. I
am figuring 5 hours for bookkeeping and banking and 10 hours for ordering parts and answering phone calls. At $15.00 per hour he is
earning $225.00 a week ($15.00 x 15 hours) and that multiplied times 52 weeks comes to $11,700 per year.

Debt Service: My financial calculator says that if you borrow $40,000 for 5 years (60 months) at 5% and the balance at the end of the 60-
month is zero, the monthly payments come to $660.49. Since the formula requires yearly figures we multiply by 12 and get $7,925.92.
Most of this payment is principal reduction but we are going to just deduct all of the payment as is generally accepted in the industry.

Return on Investment: We are going to use the 20% figure we discussed above. Formula one determined that $50,000 was needed as
an investment which is multiplied by 20% (.20) = $10,000 per year return on investment.

Formula #2 (Sellers Discretionary Earnings - Fair Market Wages (For Owner) - Debt Service - Return on Investment (Cash Requirement
x Percentage) = Extra Profit/Loss) would the look like this:

Seller Discretionary Earnings: $50,000.00

- Fair Market Wages: $11,700.00 (-)

- Debt Service: $ 7,925.00 (-)

- Return on investment: $10,000.00 (-)

= Extra Profit/Loss: $20,375.00

This means that after deducting from the income, wages, financing costs and a return on your cash investment the business still
generates $20,375 more profit. Now would you buy this business under these circumstances? It would appear, yes! Of course this is
based on a few assumptions, which might not be true. Let’s look at them again.

The owner is only working 15 hours a week or he is only doing 15 hours of real work even though he is sitting around all day. The other
assumption is that a 20% return on your investment is a sufficient return for the risk.

We can also consider that if the new owner puts in an extra 25 hours a week doing productive sales the business should be able to
afford to pay him another $20,375 for the first year. It would appear that if the sales work was done then the profit should greatly increase
in the second year or maybe even the second month.


This is a tool to help you analyze a business. It is not the end-all of a business appraisal or evaluation. This is just a tool to help increase
your understanding of a business’s value that you may be seeking to purchase. Have fun with it.

Article Source:
About the Author
Willard Michlin is a Business Broker, California Real Estate Broker, Accountant, Well known Public speaker and
Administrative/Business Consultant. He can be contacted at his Ventura, California office by calling 805-529-9854 or by e-mail at See other articles by Willard Michlin at

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