What should you care about, assets or cash flow?
When you begin the search for a business to buy, your initial tendency might be to think about buying a business in the same way you would buy a house. Buying a home or buying property means you are exchanging money for something physical – a structure or a piece of land.
Many new business buyers apply this same logic to the purchase of a business, focusing on the assets or inventory of the businesses they find interesting.
If you are buying a house, the finishes and included appliances absolutely factor into the price, but using the perceived value of the comparable physical assets found in a business (like a kitchen hood or vehicles) to judge a listing price won’t work.
Why? When you buy a business, you are buying cash flow. You are buying an income stream that is generated through the use of the assets – but the truth is most small businesses don’t have many assets to speak of. Most of the time, the physical location of a business isn’t owned by the business owner – a commercial lease is in place. In some cases, the equipment that has been installed (like the hood system in a restaurant) belongs to the landlord as well.
We will use the restaurant example to further illustrate this point. When you buy a restaurant, the expectation is that all of the equipment is in working condition, like the grill in the kitchen. You are buying the cash flow that is generated by the use of the working grill. The grill is critical to generating that cash flow, but outside the confines of the business the grill has no value on its own to a business buyer.
There are a few instances where the physical assets, like a grill, will play into price. As we just mentioned, the expectation is that everything is in working condition. Excessive equipment, not enough equipment or equipment that isn’t in decent working order can decrease the amount you as a buyer offer on a business – as in each of these scenarios you will have to make changes in order to get the business in proper working order when you take over.
It is important to note, however, that not liking the aesthetics of the equipment doesn’t mean you can discount it. If you are looking at a house with granite counter tops and you only like quartz counter tops – this aesthetic difference doesn’t mean you can take $10,000 off of your offer. The same holds true in business transactions. If the business has the necessary working equipment, then it has the necessary equipment- ugly or not. Your offer and consideration of each business should be based on cash flow, not assets.
Do you have more questions about how to evaluate the listing price of a business? Would you like to know more about how to use cash flow and multiples? Ask us! Leave any comments or questions here and we would be happy to help!
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