Business Purchase Case Study
An income statement is defined as a financial statement that companies use to measure their financial performance over a given period (Warren, Reeve, & Duchac, 2009). Precisely, it gives a summary of the company’s revenue and expenses in both operating and non-operating activities. On the other hand, 1040 Schedule C is a form filled by a sole proprietor to report his/her profit or loss from the business. The owners will fill the form when reporting their tax-deductible business expenses. In this case study, the financial statement for the business and the owner’s 1040 C business tax do not agree. It is important to note that owners of small business usually make it a common practice to hide vital information such as personal expenses in business expenses. Such a scenario has the following results that might benefit the owner of the business but according to the law, the practice is illegal. First, the owner of the business can take advantage of hiding personal expenses and take money from the business account without showing it as taxable income. Secondly, when the owner files tax return with hidden information on personal expenses, the amount of income that the business is taxed reduces (Warren, Reeve, & Duchac, 2009). Through such practice, the owner can lower his/her tax bill and reap the largest tax benefits.
Also, Sly’s explanation of the difference between his income statement and 1040 Schedule C lead us into discussing the ethical conflicts that sole proprietors experience in the business world. Other information that are critical and irrelevant to the potential buyer include the depreciation, interest, property tax, and draws of the owner. The new value for the depreciation will depend on the price that will be paid for the depreciable assets. Similarly, due to the change in ownership, the property assessment will also change. In case the new owner attempts to make draws, the action will depend on his/her needs and the future success of the business. Therefore, from the above information, it is impossible to determine the value of the business since the information provided are irrelevant.
Before a person pays for the business, he/she must put into consideration the amount to invest, the cash flows from the business and the amount of money realized from the business (Rudani, 2013). In this scenario, the business makes a profit of $60,000 on sales of $200,000. The sales return for this case is 30% which is high. The high returns rates might make a person feel suspicious, and a potential buyer would like to confirm the revenues and largest amount of expenses independently. If the $60,000 figure is confirmed to be correct, to determine the upper limit to the value of the business, we divide profits by the total cost of capital. On a further note, the rule of thumb for small business states that an individual should never assume a cost of capital that is less than 20%. Therefore, when we divide $60,000 by 20%, we get an upper limit of $300,000. This value is higher than the asking price and will automatically raise an alarm.
Ultimately, the new owner must consider the amount of cash flows he/she has. If the seller’s asking price is $240,000 and they are willing to finance $190,000 at 10% for 15 years, the new owner must have $50,000 per year to meet his/her expenses. Similarly, the approximate monthly payment will be $2,042. The current profit is $10,000 and $2,042 × 12= $24,504. When we add debt service and the desired draws, the result will exceed the current profit by $14,504. Therefore, this price is still too high.
Gwendolyn should get information on the demand for the products. He should know if the sales are growing, steady or falling. Second, he should get information on the cost of purchasing similar and used equipment from a restaurant supply. Third, he should determine if she can get an alternative and better finance source other than the owner (Rudani, 2013). Fourth, Gwendolyn should find out if there exist any contracts with the current sellers Caterwauling Coyote. Lastly, he should reconsider the reason he wants to buy the existing business. Why could she not simply make a similar source since the ingredients are listed on the label?
Rudani, R. B. (2013). Principles of Management. Tata McGraw-Hill Education.
Warren, C. S., Reeve, J. M., & Duchac, J. (2009). Financial and managerial accounting. Mason, Ohio: South-Western Cengage Learning.
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