Real profitability after buying a business

Bill I. (his real name was changed to preserve the confidentiality of the client) bought a company that deals with electrical works during the construction process.

At the time of closing the deal, the company was involved in several large projects. Initially, the deal looked pretty good, but surprises soon began to pop up.

Customers were paying very slowly, and the payroll had to be paid every week.

As a result, Bill had to deposit additional funds into the company's account to replenish working capital. As a result, the amount of invested funds increased by 20%, while the real profitability decreased by 17%.

The main problem is that after a purchase, especially in the first few months, the profit may differ from what it was before the deal was closed.

This is influenced by several factors.

First, you can purchase a business by taking out an installment plan from a seller for, say, three years. In this case, you will pay a certain amount every month. These payments will reduce the cash flow to the new owner.

Profitability is also influenced by the dynamics of sales. Seasonal fluctuations can greatly deviate from the annual average. In a scenario where the purchase falls on the low season, you need to predict a decline in cash receipts over several months. Then the situation will improve, but until that time the business owner must live.

Also, the new owner often has to hire new employees. This means that their salaries will reduce their cash flow even further. In order to eliminate the need to hire new people, you need to properly check employees. Read our article on how to do this.

It is necessary to have a license in construction and other similar businesses. The license holder is the owner. You will have to rent this license from him. These costs are also deducted from profits.

It is necessary to take into account such a factor as the rental of premises. If the purchase comes at the end of the lease, chances are you will get a higher rent. It will also reduce profitability. Read more about the lease agreement here.

An example of profitability, taking into account installments and the specifics of the enterprise

Asking Price - $800,000

Declared Profit - $200,000

Declared yield 25%

Deal structure

$600,000 initial payment

$200,000 - installment plan for three years at 6% per annum

$6,084.39 - monthly payment

$73,012.65 - annual installment payment

$200,000 - accounts receivable

$120,000 - payable

$80,000 - replenishment of working capital after purchase (difference between accounts receivable and payable)

First Year Cash Flow = $46.987.35 ($200,000 - $80,000 - $73,012.65)

First Year ROI = 8% ($46.987.35 / $600,000)

Cash flow over the next two years = $126,987.35 ($200,000 - $73,012.65)

ROI for the next 2 years = 21% ($126,987.35 / $600,000)

Starting from the 4th year, the yield is 33%. ($200,000 / $600,000)

Thus, an enterprise whose real value

$880,000 ($800,000 + $80,000)

and real ROI = 22% ($200,000 /$880,000),

was purchased for $600,000. The profitability of the first year is significantly lower than the declared one (8%). In the second and third years - approximately equal to the declared one, and starting from the 4th year - by a third higher than the declared one.

Remember!

Реальная доходность бизнеса 3

  • The reported profitability of the business will most likely not match yours after the deal is closed.
  • Consider the above factors when buying a business.
  • Be prepared that your profit will be lower than that of the previous owner (at least for the first time after the conclusion of the transaction)
  • In order not to be disappointed in the income after acquiring a business, it is worth considering the factors that affect profitability.

In order not to be disappointed in income after acquiring a business, it is worth considering all the factors that affect profitability. And you should responsibly approach the verification of all aspects of the company. Read more about the verification process in the article "Business audit - expectations and reality".

You can learn how this is done from our Business Due Diligence class.

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