A person, when he intends to purchase a business, wants to know whether the business is worth buying or not. If so, he has to ascertain whether the amount of purchase considerations payable is just and proper.
For this, the investigator should go through the Balance Sheets and the Profit and Loss Accounts for several years and make a searching enquiry to confirm that the results disclosed by these accounts are genuine and fair.
Actually, he is interested in ascertaining whether the proposal in hand will yield expected results in the form of profits in the years to come. An investigator should note the following points carefully:
(a) Earning Capacity:
The investigator in such a situation should try to assess the financial position and ensure the position of assets and liabilities as shown in the Balance Sheet. The earning capacity of a business can exactly be located by going deeply into the results disclosed by the Profit and Loss Accounts.
The trend of profits earned during the past years should be enquired into. He should calculate the percentage of gross profits and other expenses to turnover and redraft the Profit and Loss Accounts in a tabular form. If there are any new changes, he should note them carefully.
It has to be seen that the appreciation of profits is not the result of a sort of window-dressing but it is actual. Profits can be inflated as a result of inflation of sales, suppression of purchases, omission of expenses or capitalization of revenue expenditure, less or no provision for depreciation or bad debts, etc., over-valuation of stock or addition of fictitious items of income.
He should carefully go through all these details and ensure that capital profits are distinctly dealt with and are not mixed with the revenue profits. Such a procedure can bring to light the real earning capacity of the business which is being purchased.
(b) Financial Stability:
Next, he should go through the details about assets and liabilities as shown in the Balance Sheet. He should ascertain that the assets have been properly valued and depreciation has been adequately provided for. Similarly, the liabilities’ position is also real and not artificial. These are the simple things which an investigator should keep in mind.
He should confirm that the working capital is adequate. It is to be ensured that there is not much gap between the paid-up capital and Block Account. The position of availability of working capital has to be thoroughly enquired into.
He should enquire into the method of valuation of goodwill. The bases of valuation of goodwill may be either past profits or turnover. The price demanded by the vendor for goodwill should be verified with reference to the trend of past profits and other factors, e.g., its dependence upon the personality and relations of the proprietor, etc.
It has to be remembered that if the basis of calculation is the past profits, necessary adjustments for extraordinary profits or losses, capital profits or losses and similar items will have to be made.
If, on the other hand, the goodwill is calculated on the basis of turnover, it should be carefully scrutinized. If goodwill is attached to a particular place where the business is being carried on, it should be seen how far the change in proprietorship will affect it favourably or adversely.
(d) General Considerations:
The investigator should also pay attention to the following factors:
(i) It should be enquired into whether the business enjoys State protection. If so, how long will it continue? This is important as the expansion and further improvement in the affairs of a business depend to a large extent on the protection granted by the Government.
(ii) Another point to be considered is the term of credit given and received. It is true that the term of credit affects the volume of working capital and also the amount of goodwill.
(iii) It is to be seen how far the success of the business is dependent upon the qualities and character of the vendor. It is to be confirmed whether the business will enjoy similar benefits or extra gain under the new proprietorship.
(iv) Next, he should examine the possibilities of competition. This may be ascertained by reference to the terms of sale imposing any restrictions on the vendor to start another business in competition.
(v) He should also enquire into the nature of customers. It should be seen if change in the proprietorship is to affect adversely their attitude.
(vi) The attitude of employees is another important factor to be taken into account. The investigator should ensure whether they would like to continue in employment when there is change in the ownership.
(vii) The closing stock should be properly verified. This is an important item to be judiciously examined.
The investigator should submit his report to the client in clear terms indicating there in the period covered. It is expected from him that he will disclose all matters which are likely to affect the future of the business to be purchased.