Sanity Check - Buying a Business(part Iii)

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. You 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, lets 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. Lets take an owner who owns a 99-cent discount type store. This shopkeeper works 70 hours per week behind a counter in the store. You 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. You 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 wages.

DOING THE MATH

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. Lets 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.