How to Buy a Business â€“ Assessing the Profitability of a Business
In most cases, the Balance Sheet and Profit / Loss statements presented will be tax figures. You may be surprised to learn that many business owners go to considerable lengths to minimize, by legitimate means, the amount of tax payable.
This means that, in order to determine the true return to an owner of a business, we need to "add-back" certain allowable deductions in respect of financing costs and proprietorship issues not directly related to the operation of the business, to determine EBIT (Earnings Before Interest and Tax). These "add-backs" could include:
- Interest Charges and Financing Costs. These are a matter arising out of the financial circumstances of the owner of the business. You would need to factor in your own projected financing costs to determine the viability of your ownership of the business.
- Accelerated Depreciation. Often the effective working life of equipment far exceeds the time over which it is allowable to depreciate the equipment (for example, a machine with an effective life of 10 years may be depreciated over 3 years). In this case, the proportion of accelerated depreciation could be treated as an "add-back". Unless there is a real need to replace the equipment within the forseable future, depreciation is only a book entry. The tax deduction allows you to repay some principal from your loan out of Pre-tax income, so the bigger this deduction, the better.
- Expenditure of a Private Nature, such as the personal use of luxury cars, generous superannuation contributions, and other "perks" not directly related to the operation of the business.
- Salaries paid for the purpose of income splitting, to nominal or non-working Directors.
- Owner's income, in the case of owner-operated businesses. This is a controversial issue; many writers claim that ownersâ€™ income should not be considered as an "add-back". We say that the amount of income an owner draws is a personal matter, depending on the circumstances of the owner. However, the fact that the owner's income is included in the "return to Owner" figure, should be reflected in a lower multiple to be applied in valuing the business.
- Stock Write-Backs. Many businesses use a deliberate undervaluing of their stock, reducing declared profit, and effectively deferring tax liability. You would need to check the physical stock take, however, before accepting this as an "add-back", as it could just as easily be used in the opposite way.
- Capital Expenditure. In many cases, small businesses "expense" capital items, to write them off in the year of purchase, rather than depreciating the item over a number of years.
- Non-recurring expenditure, such as research & development costs, tooling, personal travel, and other creative ways of deducting from tax expenditure more for the benefit of the proprietor than the business.
- In each case, it would be necessary to verify these claims, as part of the "due diligence" process, which constitutes the last phase of the purchase process.
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Article written by Rudy Weber. Published with permission from Rudy Weber, Lloyds Business Brokers.