In these modern times of global economic activity, more and more companies are either looking to sell their company, or they look at growth by acquisition. Never has the acquisition trail been more active among the worlds’ corporate sector, as has been the case over the past few years. Why, one may ask?
Because it has become more and more difficult to ‘grow’ companies in local markets, in line with shareholder expectations, the obvious answer is to expand into other markets, or to broaden the product base. Due to good profits, many companies are well cashed up, and therefore the burden of interest rates on huge borrowings is now less of an issue that it was in previous years.
This article offers only the basic guidelines of buying and selling a business, however, it gives a very good insight into what to expect.
Many people seem to think that profitability is the only factor that influences the value of a company and its attractiveness to a buyer. Profit is important, however, what buyers usually look for is how they can leverage the purchased company into increasing the return on their owners’ equity, at a rate higher than they are currently achieving. What they do not want to buy, is a history of poor debtor management, poor stock turns, redundant assets etc. If they still want to buy a company suffering those cancers, then you can be assured that the price will come down significantly.
We will now look at what buyers would be looking at in their due diligence process before deciding on a purchase and a price they would be willing to pay.
Table 1
Table 1 represents a simplified profit and loss statement, and compares two companies in the same industry, with the same sales.
The important segment of this profit and loss is the ‘cost of sales’. This is where they will get most advantage.
The ‘operating expenses’ are often not considered particularly relevant, as if they had purchased the company, then in most cases, a large percentage of the operating expenses will be absorbed into their own structure. With this in mind, it is likely that most of the ‘rationalization’ in terms of job security will affect the operating expenses area.
Comparing the two companies ‘cost of sales’ now, the first line that attracts attention is that of direct labour. Company A clearly does not manage its direct labour as well as company B. Company A spend a lot more money, than company B on direct labour to generate the same sales!
Cost of goods sold is also a problem with company A. The reason is simply that either they do not purchase very well, or that their mark-up is too low, or a combination of both.
The same problem exists with ‘external costs’ as with ‘cost of goods sold’
Once we look at overheads, it is now apparent that Company A is poorly managed and in most cases, a buyer will look no further. If they do, it will only be to get a real rock bottom bargain, in other words for a substantially lower price.
Company B, at this point looks like a good prospect as the figures all match up to good commercial benchmarks, particularly profitability. These, however, are not the only factors of interest to a buyer.
In either case, Company A or B if the decision is to continue investigating the possibility of purchasing one of these companies, the next step will be to look at the balance sheet.
Table 2
Examining Table 2, the areas that would be of concern to a buyer for company A would be;
How did we arrive at those assumptions, and why are we assuming Company B stacks up well. It sure does against Company A, however, is company B’s balance sheet what a buyer would be interested in purchasing?
A very good question!
Now look at some important ratios, which will make the task of deciding whether to purchase and at what price, far less onerous.
Table 3
Table 3 is a summary of the important criteria a buyer would look at in determining whether to make an offer. Company B has been deliberately tailored to give managers benchmarks on what clients should achieve for their companies.
The tan segment represents profit and loss ratios, the aquamarine segment represents balance sheet ratios, and the uncoloured segment represents fixed costs.
What the balance sheet ratios mean; (We will refer to Company B’s ratios for the explanations)
When comparing company B with company A, the only area where company A scores better than company B is with Asset Turnover. The problem is that Company B has fewer current assets than company A because of their negative cash position, which has affected the Asset turnover ratio.
At this point, most potential buyers would bail out of company A, as even at a bargain price there are too many problems with the company, most of all with its management!
There are 3 simple issues that affect purchasing a company;
Table 4
Table 5
Tables 4 and 5 represent a summary of profit and loss statement for companies ‘B’ and ‘A’. Take particular notice of the annual Profit before Tax of both companies.
Table 6
Table 6 summarises the profits, averages them, then looks at 3 times and 5 times average earnings and then notes the net assets of each company.
The most common way of arriving at a quick value for a company is to look at 3 times or 5 times its profit before tax.
The net asset figure then gives a guide as to where the purchase price should be pitched. In table 6, look at company ‘B’. The purchase figure is between $611,000 and $1,018,333. The net assets, however, are close enough to $700,000.
Assuming the net assets are ‘clean’ then one could expect to pay over $700,000 but no more than $1,000,000. This of course would be subject to due diligence.
Table 7
Table 7 sets out clearly the results of the proposed purchased company, the company looking at the purchase, the combined results, and finally the leveraged results.
It is very important to have sufficient information, to establish an integration strategy BEFORE making an offer.
Assuming the final purchase figure looks like being $ 950,000, the next logical question is, “What return could be expected from this purchase?”
Table 8
Table 8 clearly shows that with good management the purchase would be worthwhile. What it means in simple English is that the company purchased should pay for itself in 2 years!
Whether you are buying or selling a business, never do it on your own. It is important to note that the tools used in this article will no doubt help the readers to do their own investigations, without the cost of experts.
Once satisfied enough to proceed, then get in the experts.
Experts are not necessarily the accountants down the street. Experts are people who specialise in mergers and acquisitions, that will include accountants and lawyers. Make sure you budget for the costs of selling and buying, as they will come back to bite you, whether prepared or not!