Before committing to purchasing a business, you must understand the business’ financial position. It is easy to get caught up in the excitement of purchasing a business that seems perfect for you. However, taking the time to investigate what you are buying and undertaking due diligence will help you make a more informed decision. This includes reviewing the business’:

  • assets;
  • business relationships; and
  • risks.

You will usually undertake due diligence after agreeing to the deal in principle, but subject to a sale of business agreement. It is important to approach due diligence through a number of lenses including legal, commercial and financial. In this article, we provide a checklist for conducting due diligence on the business’ financials and sales records.

Financial Records

One of the first things you should check is the business’ financial records to gain an understanding of the business’ performance in recent times, and predict its profitability in the future. You should ask for the financial records for at least the past three years and analyse the financial information both yourself and with the help of your accountant. The information provided by the vendor should at least include:

  • balance sheets;
  • profit and loss statements;
  • purchases and sales records; 
  • management accounts; 
  • financial forecasts; and
  • bank statements.

You are looking to see: 

  • the trends in the business;
  • its profitability;
  • how quickly it can meet its day to day liabilities; and 
  • its growth potential.

Using this, you will be able to project your future cash flow and gain an understanding of when you might breakeven. You should also consider the effect of increased and decreased sales on profits and the effect of inflation in the years to come. When you purchase a business, there are many risks, so ensuring profits are adequate to overcome this risk is important.

Sales Patterns and Records

While looking at the financial records will give you some figures on the business, understanding the sales patterns is just as important. You need to be satisfied that sales will continue and determine whether external factors influence them. Firstly, you should look at reliable sales records that are hopefully broken down by product line. Check whether there are fluctuations due to one-off sales. You should also check that you have been provided with all of the sales figures for the business. 

By analysing the sales records, you will be able to see what the sales patterns are year-by-year and month-by-month. 

For example, in a ski shop, you might notice that sales are up in winter, and down in summer, and you will need to consider if you can work with the cyclical nature of this type of business. 

In the real estate industry, you might see that there are periods of time when the market is down where fewer people buy homes. You should take these sales patterns into account when assessing the profitability of the business.

Sales Information

Sales information refers to what the business sells, how much they sell and who they sell to. You should consider the business’:

  • product or service offering – a unique product or service offering may be more marketable;
  • marketability – is the product or service likely to maintain or improve its marketability? For example, consider whether it is in a dying industry such as a video store, or if it is a tech business that could take off if the right team is involved;
  • sales targets – you should find out the minimum likely sales and maximum likely sales and whether the targets are achievable; and
  • client base – a wide client base may be less risky than one where a small percentage of clients represent a large percentage of sales. This is particularly important if the existing owner or a staff member is critical to the business’ success and has a special relationship with clients.

Warranties and Refunds

When you take over the assets of a business, you are typically not responsible for contracts entered into by the previous owner, unless they have been transferred to you. This means that you will not be responsible for refunds or warranties offered by the previous owners. 

However, in some industries, and for the goodwill of the business, clients may expect you to make refunds or warranties even when you are not legally obliged to do so. For this reason, you should check to see if any goods are under warranty and what your possible financial commitment could be to maintain the goodwill of the business.

Accounts Receivable

Accounts receivable is the amount owed to a business as a result of the business providing goods or services on credit. You should consider whether you will have to build up your own accounts receivable and how it will affect your cash flow. 

If you are buying the accounts receivable, you should understand whether:

  • there is an aged list of accounts receivable (debts that have been outstanding for a long time); or 
  • it is possible to sell the accounts receivable to a factoring agency, such as a bank or finance company, to generate cash flow into the business.

Tax

The tax considerations of purchasing a business are important because they could add unexpected costs. If you are relying on the vendor’s accountant’s valuation of the business, it may be worth gaining a second opinion from a business valuer or your accountant so that you know how much it is really worth. This will help you to be in a better position to negotiate and only pay market value.

Gaining tax advice on the sale is also prudent. A tax lawyer or accountant will be able to advise on the possible: 

  • GST;
  • capital gains tax; and 
  • other tax consequences of the sale.

For example, if you sell the business within the first 12 months of purchase, you may be subject to special capital gains tax implications.

Key Takeaways

When deciding to purchase a business, it is important to look at the business holistically and undertake due diligence to assess the risks and liabilities of the purchase. Looking into the financials and sales records of the business is important so that you can validate what the vendor has said about the business and understand the likelihood of profitability going forward. If you need assistance with the due diligence process or purchasing a business, contact LegalVision’s sale of business lawyers on 1300 544 755 or fill out the form on this page.

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