Buying and Selling a Small Business Part C
LIABILITIES AND OWNERS' EQUITY
Accounts payable......... $100,800 $120,000 9.51 12.42
Notes payable............ 0 20,000 0 2.07
Accrued taxes payable.... 1,600 2,400 0.15 0.25
Unearned revenues........ 6,000 0 0.57 0
--------- -------- ------ ------
Total current liabilities.. 108,400 142,400 10.23 14.74
Mortgage payable........... 120,000 20,000 11.32 2.07
--------- -------- ------ ------
Total liabilities.......... 228,400 162,400 21.55 16.81
--------- -------- ------ ------
Original investment...... 500,000 500,000 47.18 51.76
Retained earnings........ 331,400 303,600 31.27 31.43
--------- -------- ------ ------
Total owners' equity....... 831,400 803,600 78.45 83.19
--------- -------- ------ ------
Total liabilities and
owners' equity...........$1,059,800 $966,000 100.00 100.00
---------- -------- ------ ------
Comparative Income Statement
Years ended December 31, 1977 and 1978
1978 1977 1978 1977
---------- ---------- ------ ------
Gross sales................$1,947,000 $1,706,000 101.41 101.21
Sales returns.............. 27,000 20,400 1.41 1.21
---------- ---------- ------ ------
Net sales.................. 1,920,000 1,685,600 100.00 100.00
Less cost of goods sold.... 1,430,000 1,245,000 74.48 73.86
---------- ---------- ------ ------
Gross margin............... 490,000 440,600 25.52 26.14
---------- ---------- ------ ------
Wages paid............... 282,800 243,000 14.72 14.41
Taxes.................... 65,000 62,000 3.38 3.68
Insurance................ 48,000 48,000 2.50 2.85
Telephone................ 4,800 4,400 0.25 0.26
Miscellaneous............ 10,800 5,500 0.58 0.33
---------- --------- ------ ------
Total operating expenses... 411,400 362,900 21.43 21.53
---------- --------- ------ ------
Net income before taxes.. $78,600 $77,700 4.09 4.61
---------- --------- ------ ------
Current assets, $563,600
----------------------------- = 5.2 to 1.
Current liabilities, $108,400
Acid test or "quick ratio"
Cash plus assets near cash, $172,000
------------------------------------ = 1.6 to 1.
Current liabilities, $108,400
Days' sales uncollected
Accounts receivable, $136,000
----------------------------- x 365 = 25.5 days' sales uncollected.
Charge sales, $1,947,000
Turnover of merchandise inventory
Cost of goods sold, $1,430,000
--------------------------------------- = 3.82 times, merchandise turnover.
Average merchandise inventory, $374,000
Return on owners' investment
Net income, $78,600
---------------------------------- = 0.0987, or 9.78 percent, return on Beginning owners' equity, $803,600 investment.
Return on total assets invested
Net income, $78,600
------------------------ = 0.0742, or 7.42 percent, return on assets Total assets, $1,059,800 invested.
Owners' percentage equity in business
Owners' equity, $831,400
------------------------ = 0.7845, or 78.45 percent.
Total assets, $1,059,800
Creditors' percentage equity in business
Creditors' equity, $228,400
--------------------------- = 0.2155, or 21.55 percent.
Total assets, $1,059,800
Current ratio. This ratio compares current assets to current liabilities. In the example shown in schedule 3 above, there is $5.20 in current assets for every $1 of current liabilities.
The current ratio establishes an important relation between the business' current debt and its ability to pay the debt. The assumption is that a company should be comfortably able to pay current debts from current assets if necessary. In many businesses, however, especially service businesses, current assets are proportionately smaller because there is little inventory. In these businesses, the relation of current assets to current liabilities may be less important.
Acid test or quick ratio. This ratio points out the relation between the current assets that can be most quickly converted into cash and current liabilities. It is similar to the current ratio except that it uses only assets that are just one step away from being cash.
"One step away from cash" means that only one additional transaction is needed to convert the asset into cash. For example, accounts receivable only have to be collected and marketable securities sold. Merchandise inventories that are normally sold on credit, on the other hand, are two steps away from cash. The inventory will first be sold and accounts receivable created. Then the accounts receivable must be collected before cash is realized from the inventory.
Days' sales uncollected. Days' sales uncollected shows how fast a business collects its accounts receivable. One way to find this figure is to divide the year-end accounts receivable by the total charge sales for the year and multiply the results by 365.
For this computation to be valid, the accounts receivable must be fairly constant throughout the year. In most businesses, however, sales—and therefore accounts receivable also—tend to be higher at certain times of the year. It is better to use an average if possible.
Turnover of merchandise inventory. The turnover of merchandise inventory is the number of times the average inventory is sold during an accounting period. To find it, divide the cost of goods sold during the period covered by an average merchandise inventory at cost. A high turnover is usually a mark of good merchandising; but if the business only computes its inventory once a year, and that at the low point of the business's cycle, the turnover may appear better than it really is.
Return on owner's investment. The ratio of net income to proprietorship measures the owner's success in making a profit on the money he has invested in the business. Usually, net income after taxes and owner's equity as of the beginning of the year are used. (The beginning figure for any year is the December 31 figure for the year before.) If the owner's equity fluctuated greatly during the period, an average owner's equity should be used.
Return on total assets. This shows the return on the total investment of all who have a stake in the business, creditors as well as the owners.
Owner's percent of equity. For this percent, the year-end owner's equity is divided by the total assets. The share of the assets of a business contributed by the owner is always of interest to anyone trying to analyze the business. Creditors like to see a high proportion of ownership equity—the greater the owner's equity in proportion to that of the creditors, the greater the losses that can be absorbed by the owner before the creditors begin to suffer a loss.
Creditors' percent of equity. The ratio of creditor's claims to total assets is always 100 percent minus the owner's percent of equity.
Interpretation of Ratios and Percentages
The value of these ratios and percentages lies mainly in their use as tools of comparison rather than in their absolute values. Thus, a consistent increase or decrease in the current ratios of a business over a 5-year period establishes a pattern that may be significant. Suppose the current ratios for the 5 years are 7 to 1, 5 to 1, 4 to 1, 3 to 1, and 2 to 1.
Clearly, the ability of the business to meet its current debt is declining.
Another important use of ratios is to compare the company's performance with that of similar businesses. For almost every size and type of business, there are published ratios of expenses to sales that are accepted throughout the industry. A comparison between the ratios of the business offered for sale and averages for the trade will bring out any discrepancies. Some of the discrepancies may be due simply to poor management, but each one should be investigated.
Evaluation of Past Years' Profits
In using a net-profit figure for past years to project the future earning potential of the business, the buyer or seller should exclude the profit of any year that is unusually high or low because of exceptional circumstances. It may also be
wise to use a weighted average for the past years' profits.
Assume, for example, that two similar businesses are to be compared. Their profits for the past 5 years have been as follows:
Year Company A Company B
2................................. 14,000 6,000
3................................. 10,000 10,000
4................................. 6,000 14,000
5................................. 2,000 18,000
Both businesses show the same average profits over the 5 years and would therefore, on the basis of a simple average, be valued at the same figure. But while company A has been declining, company B has been growing. Some method is needed that will give more emphasis to the profits of the later years.
A weighted average can have this effect. How much the later profits are emphasized over the earlier years will depend on what multiplier is used, and the choice of multiplier is a matter of personal opinion. Here is an example of how a weighted average could be used to give effect to trends in comparing companies A and B:
Year Company A Company B
1..............$18,000 X 1 = $18,000 $2,000 X 1 = $2,000
2.............. 14,000 X 2 = 28,000 6,000 X 2 = 12,000
3.............. 10,000 X 3 = 30,000 10,000 X 3 = 30,000
4.............. 6,000 X 4 = 24,000 14,000 X 4 = 56,000
5.............. 2,000 X 5 = 10,000 18,000 X 5 = 90,000
-- -------- -- --------
Total........ 15 $110,000 15 $190,000
-- -------- -- --------
av.....$110,000 div. by 15 = $7,334 $190,000 div. by 15 = $12,667
In assessing the future of the business, the buyer must take into consideration any changes he plans
to make in the basic financial structure of the business, such as putting in additional capital or not buying all the assets. However, he should not pay for future profits he is going to earn by reason of his own special skills or additional investment. In determining the future income he is purchasing, therefore, he must rely largely on past results of the business operation.
Effect of Changes in Price Levels
When the buyer is analyzing several years' financial statements, he must keep in mind the effect on the statements of changes in price levels; that is, in the purchasing power of money. He should consider the possibility of converting the amounts on the financial statements to a base year.
Putting a Value on Goodwill
Goodwill, when it exists, is a valuable asset. It may result from a good reputation, a convenient location, efficient and courteous treatment of customers, or other causes. However, because it is intangible and difficult to measure, goodwill is sometimes recorded when it does not exist.
From the accountants' standpoint, goodwill should be recorded only when it is purchased. It should not be recorded otherwise, they believe, because of the difficulty of placing a fair value on it.
As a practical matter, above-average earnings are normally considered the best evidence of the existence of
goodwill, and the value placed on the goodwill at the time of its sale is often determined by capitalizing these extra earnings. Take, for example, a business in a field in which the normal return on investment is 10 percent. Suppose the business has a capital investment of $200,000 and an annual return of about $24,000. The average return on $200,000 for this type of business would be $20,000 a year. Therefore, the business has above-average earnings of $4,000 yearly.
Capitalizing these above-average earnings at 10 percent ($4,000 div. by .10) gives $40,000 as the investment needed to earn the $4,000. Therefore $40,000 may be taken as the value of the goodwill of this firm.
Many people feel that unless a business has above-average earnings, it does not have
goodwill. Thus, a business might appear to have an excellent location, enlightened customer policies, and a superb product; yet this business will not have goodwill attaching to it unless its earnings exceed the normal earnings for that type of business.
The measurement of goodwill has many pitfalls. To begin with, a decision must be made as to what normal earnings are. (Industry averages
will probably be available, but average earnings for the industry aren't necessarily normal earnings.) And once this decision has been made, the percent at which the above-normal earnings will be capitalized must be decided. In the example given, 10 percent was used. This means that the buyer should recover his investment in 10 years. If he wants to recover his investment more quickly, he will want to use a higher percent, which will give a lower capitalized value. If he is willing to wait
longer, he will accept a lower percent, which will raise the capitalized value.
Goodwill is simply a bookkeeping device to represent the value of one part of a business when that business is valued as a whole. In most cases, the total value of the business is decided without a detailed calculation of the goodwill figure—in many cases, without even detailed consideration of the value of
the other assets.
1. Get financial statements for the past 10 years or as long as the business has been in operation.
2. Make whatever revaluations of the financial statements are necessary to make the statements realistic.
3. Prepare ratios and percentages as needed.
4. Compare results of the company's operations from year to year in the past and with results in the industry at large.
Questions To Be Considered by the Buyer
1. What will happen to the profit when I take over the business?
2. How good is the accounting system that has been used?
3. How good is the cost system?
4. How realistic are the budgets?
5. How much owner's personal expense has been charged to or absorbed by the business?
6. Is there an equipment record—for insurance and to tell me what it costs to maintain various types of machinery?
7. Is the insurance adequate?
8. What have the financing arrangements been, particularly if sources other than a bank were used?
9. What is the rate of return on capital invested and what rate of return do I want for my capital investment?
Part 5 Analyzing the Market Position of the Company
Introduction: Market Analysis
EVERY BUYER, and indeed every seller, should have some measurement of what the future will offer. This includes not only the possibility of maintaining the same volume of sales as in the past, but also the opportunity to increase sales.
The buyer must have some idea of what he is acquiring besides the
physical assets of the business. He is, in fact, investing in or obligating himself to the continued operation of the business. The true value to him lies in the ability of the business to generate sales at lease equal to its current position in the market. This calls for a careful investigation and analysis of two factors: (1) the past growth of the company within the market of which it is a part, and (2) a forecast of the future sales pattern.
The seller also needs a market analysis for the business he proposes to sell. He wants the best possible price for the business—and the better the outlook, the more likely the buyer is to agree to the asking price.
Who Does the Work?
Will a single market analysis fill the needs of both buyer and seller? Separate studies are probably better. The seller has access to data about the business that are not available to the buyer. Unless the buyer has had wide and recent experience in the same kind of business, he may—rightly or wrongly—tend to rely on the seller's statement of the market position of the company.
No two studies of the same company will produce exactly the same results. The buyer's analysis is almost certain to be on the conservative side, and a compromise will be necessary.
Another question is whether the buyer and seller should conduct their own market studies or hire specialists to do it. The
detailed and complex type of investigation conducted by a professional market analyst is valuable, of course, but the cost is considerable.
The basic purpose of a market analysis in the buy-sell situation is to get a clearer picture of the company in the marketing scheme and some indication of the general direction in which it is moving. The buyer and seller should be able to gather and
analyze the basic data they need for this purpose—if they avoid a highly statistical approach.
Organizing the Study
Part 5 includes five series of questions and a checklist to guide the buyer or seller in his analysis of the market position of the business.
Sample rating charts
¦COMPANY SALES: ¦
¦ Dollar Percent ¦
¦ Year sales change ¦
¦1974.................................. $__________ ___________ ¦
¦1975.................................. ___________ ___________ ¦
¦1976.................................. ___________ ___________ ¦
¦1977.................................. ___________ ___________ ¦
¦1978.................................. ___________ ___________ ¦
¦Dollar increase 1978 over 1974........ $__________ ___________ ¦
¦Percent increase 1978 over 1974.................... ___________ ¦
¦How satisfactory? 1 2 3 4 5 ¦
¦SHARE OF MARKET: ¦
¦ Share of ¦
¦ Industry Company market ¦
¦ Year sales sales (percent) ¦
¦1974................ $____________ $______________ ___________ ¦
¦1975................ _____________ _______________ ___________ ¦
¦1976................ _____________ _______________ ___________ ¦
¦1977................ _____________ _______________ ___________ ¦
¦1978................ _____________ _______________ ___________ ¦
¦Change in share of market 1978 over 1974............ ___________ ¦
¦How satisfactory? 1 2 3 4 5 ¦
The list of questions is not complete, and not all of those given will be equally useful for all types of businesses. The nature of the business determines what kind of information is needed and in what detail. The questions will, however, call attention to some aspects of the market that might otherwise be overlooked.
Determining how important to the business a specific market characteristic is presents a problem. What is vital to one company may be unimportant to another. And some system should be worked out for rating each characteristic.
A possible method for this is to list the major subject areas in
the study, showing their relative importance, and then to rate them according to a uniform system—a rating scale using numbers, for instance, or words such as "high," "medium," "low," and "not significant." An example of how a numbered scale might work in rating the company's sales over time (one of the characteristics most likely to be studied) is shown in the box above.
Chapter 12 - The Market
THE STRENGTH OF A MARKET depends on three elements: population, income, and motivation or attitude. The first two can be measured with some accuracy and predicted statistically. Motivation, being subjective, cannot be easily observed and is largely unpredictable.
Population in the Market Area
Population, particularly the pattern within the given market, is a dominant element in the market prospects of a business. Changes in age distribution of the population will be important to some types of businesses. Migratory factors such as shifts from rural to urban and from urban to suburban may determine the future growth of others.
Many businesses, such as food stores, will be influenced principally by the total growth in population. Others will feel the impact of structural changes—the older group with its special requirements, the increase in the infant market.
Rapidly growing communities show a larger-than-normal proportion of young
families; areas with a static or declining population, a larger-than-normal proportion of older families. How permanent the population in the market is must be considered. In areas where employment is seasonal or cyclical, a large part of the population may be only semipermanent.
An analysis of population consists of more than simply counting noses. It requires a careful study of both
qualitative and quantitative characteristics.
Questions in the Analysis of Population
1. What has been the change in total population in this market area over the past 10 years?
A comparison of census figures will show these changes. The use of census tracts in major metropolitan market areas is helpful. Many city and county government units compile population figures on various geographical bases.
2. Using a given year in the past as a base, what has been the annual and cumulative percent of change in population in this market area?
The cumulative percent of change is found by dividing each succeeding year by the first year. It shows as a percent how each year up to the present compares with the base year. Plotting the figures on a graph helps to visualize the progressive change.
3. What is the average family size? Has this been increasing or decreasing?
In many consumer-goods businesses, the size of the average family unit may be more important than total population, particularly where there are observed changes in family size. Increase in the size of the family unit has had a profound effect on many classes of consumer goods, from station wagons to outdoor gym sets.
4. What is the population in this market measured in family units?
The rate of change in family units will not be the same as the rate of change in total population if the size of the average family unit is changing.
5. What is the current distribution by age groups in the market? How has this distribution changed in the past 10 years?
Nationwide, the age distribution of the population is not the same as it was a few years ago. The under-5 and over-65 groups probably show the greatest rate of change. The buyer should know whether the seller has been alert to these changing patterns and is taking advantage of them.
6. What percent of the population in this market can be classified as urban, suburban, rural? How has this changed over the past 10 years?
Changing living patterns and habits change the demand patterns for various types of goods and services. If population shifts are changing the market or shows signs of being about to do so, the businessman must try to determine how much effect this has or is likely to have on his operation.
7. What percent of the family units in this market have only one person?
Two? Three? Four? More?
A breakdown of family units by number of persons in the family has value for businesses whose sales volume is at least somewhat related to family size. A manufacturer of outdoor portable swimming pools, for instance, would be interested in family sizes because this would influence the production of various sizes of pools.
8. What percent of the total population or family units are potential customers for this kind of business?
This is particularly important for businesses whose goods or services are related to the way people live. The demand for three-horsepower garden tractors will depend on the number of families living on small acreages. Septic tank sales will depend on the families not eligible for public sewerage services. An analysis of the market for specialized goods and services may be the key to evaluating the future of the business.
9. How has the total population been changing over the past 10 years? Is it—
Increasing at an increasing rate?
Increasing at a decreasing rate?
Showing no change?
Decreasing at a decreasing rate?
Decreasing at an increasing rate?
Population may be continuing to increase, but at a slower rate. This would probably suggest less in-migration and more out-migration, or perhaps a reduced birth rate, though this would probably occur over a fairly long period of time. Analysis of vital statistics of the market (births over deaths) is advisable.
10. What is the level of education in the market? Is it increasing? What is the rate of increase? What is the level of education by age groups in the adult population? Education of the male population? Female population?
Generally, the higher the education level, the higher the income level is likely to be, with correspondingly greater capacity for goods and services. Trends in the level of education, particularly when correlated with income, may indicate future potential.
Income in the Market Area
Income as used here refers to net spendable income rather than gross earnings. Of the spendable income, the primary concern is with that which remains after fixed or relatively fixed obligations have been met—rent or home payments, utility payments, insurance premiums, and the like. The amount left is the income over which the consumer has some control—whether to spend all of it or some.
How each consumer spends this income is largely a matter of personal motivation. The total amount available for consumption in the market, however, depends on the economic factors influencing income. Variations in total income and the resulting purchasing power stem largely from two sources: (1) changes in the average income of the family unit, with the same general level of employment
prevailing; and (2) changes in the level of employment with the average income constant.
The difference between earned income and real income must also be recognized. If the cost of living is increasing at a rate about equal to the purchasing power, there is no gain in purchasing power. Dollar purchases may increase, but each dollar buys less. The net difference between the increase in
income and the increase in prices reflects the true gain or loss in income converted to purchasing power.
Some classes of goods and services show no positive relation between demand and income levels. For example, when incomes rise, more dollars are spent for food, but the percent of income channeled into these goods is smaller.
Income is important in market analysis because changes in income are reflected in the demand patterns for goods and services. No business is free from this effect. As barbershop prices increase, the interval between haircuts increases and the sale of hair clippers for home use rises. The demand for funerals in a rising market does not change, but the degree of ornateness in the casket or services decreases.
Questions in the Analysis of Income
1. What is the total spendable income within the market area? What is the average per capita income? Average per family income?
2. What has been the rate of change in income (per capita, per family) over the past 10 years on both a year-to-year basis and a cumulative basis?
Changes in income reflect the changing status of the market. The change is most likely to be an increase, but the extent of the increase should be known.
3. How does the rate of change in income in this market compare with changes in the Nation as a whole and in similar markets?
The economic factors affecting the income status of a given market may differ from those at work in the economy as a whole, but it is helpful to know how changes in this market compare with trends in other markets.
4. What is the distribution of income and purchasing power by income class in the market?
A frequency distribution such as this can be used to analyze income and purchasing power:
Percent of Percent of total
Distribution family units purchasing power
$0 to $4,999 ______________ ________________
$5,000 to $7,999 ______________ ________________
$8,000 to $13,999 ______________ ________________
$14,000 to $19,999 ______________ ________________
$20,000 and over ______________ ________________
The $8,000 to $13,999 income group, for instance, might represent 32 percent of all family units and 38 percent of the purchasing power; the $20,000-and-over group, 5 percent of the family units and 11 percent of the purchasing power. The higher-income groups will ordinarily be smaller, but they will have a higher-than-proportionate purchasing power.
5. How has the distribution of income and purchasing power by income classes changed over the past 10 years?
This information should be reduced to year-to-year and cumulative percentages.
6. What are the types of employment and the percentage of the working force in each class?
Here, again, changes over time should be studied.
7. Have there been any significant changes in the forms of employment in this market over the past 10 years? What changes in industry and employment in this market are foreseeable?
8. What is the level of unemployment in this market area? Is unemployment increasing? Decreasing? Showing no appreciable change?
Knowledge of the unemployment trend is important because of the direct effect it has on purchasing power and the psychological effect of the threat of unemployment.
9. How much do consumers typically spend for various classes of goods and services in this kind of market?
Competition in the Market Area
The buyer of a business not only acquires the physical property of the company; he also inherits its competition. He will probably be able to do little or nothing to lessen the competitive pressure operating against him, but he can develop a clear working knowledge of what he will face—the state of competition, the relative strength of the business within the market, the general patterns of development and change. A detailed analysis of the competition is highly desirable in deciding whether to buy an existing business.
Attention should be given first to competitors of about the same type and size as the business in question, since they are on a more realistic level of competition. A small clothing store would be wise to concern itself with other small clothing stores rather than with a high-volume department store. In time, a small operation might grow to the point of competing successfully with major firms, but the immediate pull of competition will come from other businesses of about the same size and description.
Investigation of large businesses, if any is made, should concern the extent to which they enlarge the total market, stimulate demand, or otherwise open up market possibilities to the smaller business.
Questions in the Analysis of Competition
1. How many competitive businesses are there within the market area of this business? Where are they located? What can be found out about them? From whom?
The market area in this sense is the trade area in which the business operates. In a retail, wholesale, or service business, this trade area may be rather narrowly defined. In a manufacturing or mail-order business, there may be a number of markets—regional, national, and perhaps even international.
Markets can be further defined as either consumer-goods markets or industrial goods markets, depending on the nature of the business and the goods or services with which it deals. The market or markets must be carefully identified to avoid any waste of time and effort in making the analysis.
2. How many competitive businesses have gone out of business or moved out of the market area within the past year?
If there has been a decline in the number of competitors, an attempt should be made to find out why. If the decline has been significant, it may indicate that there are too many businesses of that type for the potential sales volume. If other areas of the analysis tend to indicate a declining market, exodus of competing businesses may help support those findings.
3. How many competitive businesses have opened in this market area within the past year?
Is this increase in competition more than should normally be expected? What circumstances have been responsible for the increase in competition? Can the market support all these businesses?
Unless the market grows in proportion to new competitive entries, the net result is a smaller share for each competitor.
4. What is the total known or estimated volume of competitive business within the market area?
This should give a cross-check on the volume of business done by the company up for sale. The total sales estimate for the market less that done by the company gives a reasonably accurate estimate of the volume going to the competition. Or the sales of the company can be estimated by subtracting competitors' sales from total sales in the market.
5. What sort of sales effort does the competition make?
How do the competitors advertise, promote? What advertising media are used?
What is the quality of competitors' sales forces? Could business be drawn from competitors by improving on their sales ability?
There is likely to be considerable variation in the level of sales effort between competitors in the same market, from those who are highly aggressive to those who simply "follow the crowd." The person investigating the market should analyze competition from this point of view as intensively as possible.
6. What is the total footage of all competitive businesses within the market area?
From the total gross footage and total estimated volume, it is possible to get an overall sales-per-square-foot average to compare with the company under consideration.
7. What is the general physical appearance of competitive establishments in the market area?
Generally speaking, alert, progressive firms present an up-to-date physical appearance and use the newest techniques of operation. A generally high level of overall appearance gives some indication of the aggressiveness of the competition.
8. What other competitive businesses are known to be for sale within the market area?
If general business conditions are such that other competitors are seeking to get out of the market, the prospective buyer should know it. It may signify that the area is not a good one for entering business. On the other hand, a lessening of competition leaves to the business in question a larger potential volume. The reasons why competitors have left the market area should be learned. A decision to purchase assumes economic health in the market.
9. What other kinds of businesses are in indirect competition—that is, deal at least to some extent in the same kinds of goods or services as the business being considered for sale or purchase?
Businesses are constantly adding lines of merchandise, expanding services offered, and creating new products. As a result, the pattern of competition changes rapidly. The buyer, and presumably the seller, should be aware of these changes and their likely effect on the business in question.
10. Can the competitive businesses be rated, taking all factors into account, from the strongest or most dominant to the weakest?
What characteristics of the strongest competitors should be studied with an eye to improving the business being bought or sold? What weaknesses of the competition might the buyer or seller be able to capitalize on?
11. What kinds of services to customers are competitors offering that this business does not?
Customer services are becoming a dominant force in attracting and holding customers. Services offered to customers by competitors should be investigated carefully to determine the effect these have on attracting sales volume.
12. What are the general pricing policies of competitors?
An actual price comparison of specific products or services should be made. Attention should be concentrated on general price levels rather than specific items—the purpose is to compare this company and its competition, taking into account cost of merchandise, relation with sources of supply, cost of operation and so on.
13. How influential has the competition been in enlarging the overall market?
Demand is classified in two ways: primary demand, which is the demand for certain kinds of goods or services, and selective demand, which is demand for a given brand or desire to purchase from a specific company. Competition, through promotion and sales effort, must be able to enlarge market capacity for a product by type or class. The combined sales effort of all appliance stores in a market, for example, will expand the primary demand for air conditioning. Thus the separate but total force of competition may have the positive effect of expanding the basic market.
14. How does the competition compare with the business in the buy-sell transaction as to the amount apparently spent on sales effort?
The nature and extent of advertising and promotion is often a strong indicator of the competitive intensity of business within a market. As the
market becomes more competitive, sales-effort costs as a percentage of sales tend to rise. A study of competitive advertising and promotion—the media and methods used, the form the promotion follows—would be of value in the market analysis.
15. Is there evidence of concerted or cooperative effort on the part of the competition to increase the total market?
Through trade associations? Joint promotional programs? How effective does the effort appear to be?
Chapter 13 - The Company
Just as important as a study of the market as a whole is a study of the position in that market of the company under existing conditions.
When a brand new business is being opened, the prospective owner has some choice about location. In buying a going concern, this is seldom possible.
The seller is not likely to sell the assets of the firm with the understanding that the buyer will find other premises. Neither is it likely that the buyer will acquire the assets and then seek other quarters from which to operate. Location, then, remains as it is at the time of the buy-sell transaction. The buyer should give careful thought to the location of the business he is considering, particularly in the relation to the market of which it is part.
Questions in the Analysis of Location
1. Is there any possibility that the status of this location will change in the foreseeable future?
Urban renewal programs, for example, have a
direct effect on business locations as well as on residential buildings. The buyer should look carefully into the possibility that the area will become a target for urban development that would require him to vacate the premises. The same investigation should be made in connection with other forms of development that might cause land condemnation or change of status—highways, flood-control projects, military uses, rezoning, and the like.
2. What specific factors should be examined in determining the desirability of the location?
The following outline suggests point that should be considered in evaluating the location of a retail store. It can be adapted for use with other types of businesses.
Checklist for Locating a Store
City or Town
1. Economic considerations
Old and well established
Old and receiving
New and promising
Recent and uncertain
Many and varied industries
Many of the same type
Few but varied
Dependent on one industry
Little or no seasonal change
Mild seasonal change
Periodic—every few years
Highly seasonal in nature
Mostly middle income
Large and stable
Small and stable
Pay substantial rent
Pay moderate rent
Pay low rent
Number of competing stores
Type of management
Alert and progressive
Presence of chains
Many well established
Type of competing stores
4. The town as a place to live
Character of the city
Are homes neat and clean, or run down and shabby?
Are lawns, parks, streets and so neat, modern, and generally
Are adequate facilities available?
Medical and dental services
Is the climate satisfactory for the type of business you are considering?
Number of independent stores of the same kind as yours
Same side of the street
Across the street
Number of chain stores
In the same block
Same side of the street
Across the street
Kind of stores next door
Number of vacancies
Same side of the street
Across the street
Dollar sales of your nearest competitor
2. Traffic flow
Sex of pedestrians
Age of pedestrians
Destination of pedestrians
Number of passersby
Automobile traffic count
Peak hours of traffic flow
Kind (bus, streetcar, auto, railroad)
4. Parking facilities
5. Side of street
Frontage and depth—in feet
Shape of building
Heat—type, air conditioning
Front and back entrances
7. Corner location—if not, what is it?
8. Unfavorable characteristics
Vacant lot—without parking possibilities
Smoke, dust, odors
Poor sidewalks and pavement
Unsightly neighborhood buildings
9. Professional men in block
10. History of the site
The discussion here concerns the nature of the company's effort and measurement of its cost against the resulting sales. For practical purposes, selling effort can be classified as indirect and direct. Indirect sales effort includes all forms of nonpersonal customer-oriented advertising and promotion. Direct sales effort is the performance of persons directly engaged in selling the merchandise or services offered.
Questions in the Analysis of Sales Effort
1. How much was spent for advertising during the past year? How much per year for the past 10 years?
These figures should be reduced to percent of change so that the results
over time can be studied
2. What advertising media were used and what percent or estimated percent of the total advertising expenditures went to each medium?
Magazines—kinds of magazines?
Broadcast media—radio, television?
Other forms of advertising?
The question is whether the media being used are a reasonable choice considering the amount that can be spent.
3. What changes have been made in the use of advertising media? Is the company relying more on one form of advertising than the past? If so, why the change?
No one advertising medium is best for all types of business. There is sometimes a tendency, however, to switch media too often, without giving any medium enough time to show its real value.
4. How does the cycle of advertising vary in relation to seasonal sales fluctuations? As sales increase, do advertising costs increase in about the same proportion? What is the pattern?
Dollar advertising expenditures usually rise as sales volume rises but not as fast percentage-wise. When sales drop, there is a tendency to spend either too much or too little in relation to normal seasonal changes, depending on the urgency felt by the advertiser.
5. If advertising allowances are available from vendors or sources of supply, is the company taking advantage of them? What kinds are available?
Advertising allowances, if properly used, make it possible to do more advertising with less money. An alert advertiser will take advantage of all advertising allowances he feels to be reasonable and useful to his business.
6. Is the company taking advantage of other available promotional services such as newspaper mats and so on?
Many suppliers offer advertising services that help improve the quality of the advertising, reduce the cost, or perhaps both. The company's use of all advertising and promotional helps should be analyzed.
7. What percent of sales was spent on advertising last year? For the past 10 years? Is this increasing? Decreasing?
It is important to know not only changes in the pattern of advertising expenditures, but the relation between these changes and changes in sales volume.
8. How do the advertising and promotion costs of this business compare with typical or average figures for this kind of business? Higher? Lower? About the same?
Figures are available from trade sources and other reporting agencies that will give standard of comparison.
9. Are other forms of promotion being used effectively? Window display?
Interior layout and display?
For many kinds of many kinds of businesses, other promotion methods may be as important as media advertising, or even more so. All possibilities should be studied as to their importance in the business under consideration.
10. Is the company capitalizing on all special promotion events suitable to the business?
This point covers a wide range of activity. Examples might be maximizing sales effort at the seasonal peak or peaks of the business, using trading stamps or other premiums, participating with sources of supply in special promotions, and so on.
11. What percent of sales has gone into selling-payroll costs for the past 10 years? What has been the trend? Are selling costs increasing, remaining about the same?
Changes in selling costs should be studied singly, in comparison to changes in sales volume, and in comparison to standards or averages for businesses of the same kind.
12. What is the quality of the selling effort of this company as shown by such factors as training, sales attitude, methods of compensation, and the like?
Selling-payroll costs as a measure of sales effort do not reveal the forces at work behind this effort and effecting its quality. Motivation of sales personnel through training, method and amount of compensation, and sales management should also be considered.
The history of sales growth within the company and in relation to similar businesses is considered the principal measure of company progress. The buyer or seller should note three types of variations that influence sales and how each may effect the buy-sell transaction.
Seasonal fluctuations. All businesses are affected to some extend by seasonal variations in the demand for goods or services. These variations may be the result of numerous factors—buyer motivation, weather, specific events. Their nature, causes, and extent should be identified as fully as possible. Some are reasonably predictable; others are not.
The prospective buyer of a business should think in terms of completing the purchase just before the maximum seasonal peak of the company. This will give him the greatest possible short-term gain and return on investment. Buying a business immediately after the maximum seasonal peak puts an additional burden on short-term working capital.
The seller is likely to take the opposite view. He is most likely to want to sell immediately after the seasonal peak of the company, thus realizing the best possible profit. (It is assumed here that in relation to sales peaks and valleys would have no appreciable effect on the market or replacement value of assets other than merchandise.)
Cyclical fluctuations. Cyclical fluctuations are changes that occur over a longer period of time but tend to appear somewhat regularly. Periods of depression and prosperity will obviously affect the future of a business. The major difficulty is to determine what effect such fluctuations will have on the businesses being bought or sold.
Long-range trends. Long-range patterns of change in an industry or a given business fall within this classification. The interplay of forces creating such trends is extremely complex, but the buyer in particular should be alert for changing patterns in his industry or market that are likely to affect the future of the business.
Questions in the Analysis of Sales
1. What has been the year-to-year change in dollar sales?
The length of time to use is largely a matter of judgement. If the figures are later to be used to make projections, a 10-year period or more is not unreasonable if the company has been in business that long. Converting the dollar figures to yearly percent of change and plotting them on a graph makes them easier to interpret.
2. Using a given year in the past as a base, what has been the cumulative rate of change up to the present?
Again, plotting the figures on a graph helps to visualize the changes.
3. What has been the percent of change in sales, year-to-year and cumulative, for this kind of business on a national or other basis?
The year should be comparable to those used in questions 1 and 2 so that the pattern of change for the company can be compared with that for like businesses.
4. How much of the increase or decrease in sales can be attributed to increasing or decreasing prices and how much to real sales?
The fact that sales have shown an increase may lead to a false conclusion that the company has shown good growth. In some types of businesses, merchandise costs have increased rapidly. An average increase of 2 percent per year in sales over 5 years changes in significance when it is known that prices have increased 8 percent during the same period. Consumer and wholesale price indexes should be checked, as well as other factors that may indicate rising prices.
5. Have prices in this company increased more rapidly, less rapidly, or at about the same rate as those in this kind of business generally?
It is important to know how the business compares in this respect with similar firms. If it is out of line, what is the reason?
6. Over a period of years, what has been the change in the level of sales for this business as compared to all businesses of this type? Are sales—
Increasing percentage-wise more than normal?
Increasing about the same rate?
Increasing less than normal?
Showing no increase at all?
Decreasing less than normal if like businesses are decreasing?
Decreasing at about the same rate?
Decreasing more than normal?
7. What is causing the increase or decrease in sales (a) for this company and (b) for similar businesses?
This point may prove to be the one that basically determines the decision to buy or sell the business.
8. Has the rate of change in sales been increasing?
Are sales increasing more rapidly now than, say, a year or two ago? Are sales increasing less rapidly now? If sales are decreasing, has the rate of decrease increased or lessened?
9. At the same time of the study, where does the business stand seasonally?
Is this normally the low point for sales in this kind of business? Is it the high point? Somewhere in between? Is seasonal variation so minor as to have little or no significance? Are seasonal variation predictable?
Seasonal variations may have a strong bearing on when the buyer is willing to purchase, when the seller is willing to sell, and the price.
10. What percentage of the year's business is done each month? What is the monthly average over the past several years?
Monthly sales averages help to determine immediate working capital requirements and to plan sales for the months ahead. They are especially important when the sales of a given month as a percent of the year's total do not vary greatly from year to year. If there has been considerable variation, the reasons for it should be identified if possible.
11. Do there appear to be any changes in the seasonal pattern of sales? If so, what appears to be causing these changes?
Changes in consumer buying habits, the pressure of increased competition, governmental regulations, and the like create changes over time that may affect the short-term sales cycle of the business.
12. If a change in the seasonal pattern is occurring, does it tend to increase total sales or merely shift the volume from one month to another?
A comparison of several years' sales may show that the overall effect is not a proportionate gain in total business but a readjustment of sales from month to month throughout the year.
13. If cyclical changes have any effect on this kind of business, what is the nature of the fluctuations? How often do they occur? With what intensity?
14. Have sales of this business in the past tended to show the effect of these cyclical fluctuations? To what extent? Intensity?
Knowing the effect of cyclical changes on the business may give some idea of what can be expected from the standpoint of intermediate-range planning and forecasting.
15. If the business is influenced by cyclical fluctuations, at what stage is the cycle at the time of the study?
Cyclical fluctuations may be the result of broad-scale economic circumstances, but the intermediate effect on a given business may not be in proportion to normal economic indicators.
16. What is the ratio of operating expenses to sales in the most recent operating statement?
A comparison of these costs with ratios or averages of similar businesses should give an indication of the operating efficiency.
17. What has been the year-to-year and average ratio of operating expenses to sales for past years?
Have operating expenses tended to increase, decrease, or remain about the same in relation to sales?
Has the relative change in operating expenses been about equal to, greater than, or less than the relative change in sales?
On a cumulative basis, what has been the change in the pattern of operating expenses over the past years?
18. Are selling costs (sales, salaries, advertising, delivery) increasing, decreasing, or remaining the same in relation to sales?
If selling costs are increasing faster than sales, each dollar spent on selling effort is bringing in a smaller return. This information may suggest possible ways of increasing the efficiency of the company's sales effort.
19. What is the ratio of net sales to gross sales and what has been the trend of this ratio over the past years?
An increase in the difference between net and gross sales may indicate weaknesses within the company in policy, sales effectiveness, merchandising, quality control, or a combination of the two or more of these factors.
20. What are the reasons for customer returns and allowances and what action is being taken to reduce them, if reduction is possible?
Care should be taken in analyzing the sales of a company to see that gross sales are not taken as net sales, particularly if lenient returns and allowances have been a part of the sales program.
21. What has been the pattern in the value of the average transaction over the past years?
Sales may be stationary, but the number of transactions may increase or decrease, thus changing the value of the average sale. Or sales may be changing but disproportionately to transactions. The ideal to be sought in an increase both in the value of the transactions and in their number.
22. How do transactions in this business compare in average value and number with those of similar businesses throughout the industry or market area?
This will give a standard of comparison to show how well the company has been able to realize an average sale in terms of what it would be normal to expect.
23. What are the current sales per square foot of floor space for the business? What has been the trend in sales per square foot for the past several years? How does this compare to known averages or ratios for other businesses of this type?
The purpose of this analysis is to estimate how efficiently space is being used for sales purposes. It may be figured on the basis of total gross footage, including area used for other than selling purposes, or it may be limited to the space devoted primarily to selling and merchandising.
Chapter 14 - The Sales Forecast
When the business and the market have been analyzed, the probable sales volume of the business can be forecast. This forecast should be a simple projection of the business involved; it should not be an attempt to forecast or project the total state of the market. The variables that influence the market are too vast and complex for a small businessman to do anything about. It will have to be assumed that what has happened to establish the condition of the market as it is, will continue to have the same general effect, at least for the period just ahead.
This is a dangerous assumption—markets and the economy are dynamic, not static—but from the practical point of view, there is little choice. In any case, it is usually over longer periods of time that changing market factors make themselves felt.
Sales Forecast vs. Sales Potential
A distinction is necessary here between making a sales forecast and estimating sales potential. A sales forecast is based on past sales performance and a reckoning of known and anticipated market conditions. From these, the expected sales level is determined.
Sales potential, on the other hand, is a measure of the capacity of the
business to reach a certain volume of sales. It is based on knowledge of
the market and the extent of competitive influence, and it involves the use
of strategy through sales effort. Past sales performance may bear little or
no resemblance to sales potential. In general, sales potential is likely to
represent a higher sales level than a sales forecast
Length of the Forecast
For the purposes of a buy-sell transaction a short-term or at most an intermediate-term forecast is all that should be attempted. Short-term forecasts cover a few months-seldom more than a year. Intermediate-term forecasts should be limited to 1 or 2 years.
The Information Needed
Since the forecast is based on past sales of the company, it is necessary to know the dollar sales volume of the firm for the past several years. If not enough sales data have been recorded, it may be necessary to improvise.
In one instance, the prospective buyer of a self-service laundry was unable to get sales figures. He contacted the manufacturer of the washing machines to determine the amount of water used per machine load. He then learned from the water company the amount of water consumed by the business. Using these two figures and making allowances for water used for drinking, rest room, and so on, he computed the number of loads washed per month. This figure multiplied by the price charged per load gave him a reasonably accurate figure for the sales volume.
Short-Term Sales Forecasting
For a short-term forecast, it is usually enough to know the sales for the past few weeks or months in comparison with the corresponding period of the year before. If sales for the past 4 weeks were 8 percent more than the corresponding 4 weeks of the preceding year, sales for the next few weeks can reasonably be expected to be 8 percent ahead of the corresponding period a year ago.
Adjustments have to be made, of course, for any known or predicted conditions that will change this rate of increase—conditions such as unusual weather, short-lived labor disputes, changes in the dates of events such as Easter, and so on.
Distribution of sales by months. A longer method of forecasting is based on the distribution of sales by months. This method works best if the monthly variations over a period of years have been small.
Suppose, for instance, that a short-term forecast is being made in June. For the past several years, sale in July have been between 11 and 13 percent of annual sales, with an average of 12.5 percent. During the same period, May sales have averaged 10 percent of annual sales. Sales during the May just past were $16,000. Then $16,000 div. by .10 = $160,000, the estimated annual sales. Projected sales for July will be 12.5 percent of $160,000, or $20,000. Sales for other months can be forecast in the same way.
Cumulative percents. Another method of short-term forecasting is the cumulative-percent method. The percent of total sales is figured for each week during the past year and added to the percent for preceding weeks, as shown in this example:
Weeks percent percent
1 .9 .9
2 1.1 2.0
3 1.4 3.4
4 1.7 5.1
5 1.9 7.0
6 2.4 9.4
7 2.6 12.0
8 2.9 14.9
9 3.1 18.0
If sales during the first 4 weeks amount to $8,000, the annual total will be estimated at $8,000 div. by .51, or $156,682. To forecast sales for the next 4 weeks, add the percentages for those weeks and multiply the annual estimate by the result ($156,862 div. by .098 = $15,372). This method works best for goods or services that are not subject to wide variations in sales volume and whose prices do not fluctuate greatly.
Number of sales transactions. Where prices tend to vary, the number of sales transactions may show a steadier trend than dollar sales do. An increase in dollar sales without an increase in the number of transactions means that the average dollar value per transaction has gone up. This increase in the amount of the average sale may mean (1) that customers are buying higher-quality goods, (2) that they are buying in larger quantities, or (3) that prices have increased.
If the level of transactions is steadier than the dollar sales, the forecast tends to be more conservative. A study of the transactions may bring to light factors not revealed by total dollar sales.
Intermediate-Term Sales Forecasting
Because of the combination of variables at work in the market, the techniques used in the short-term forecast are not reliable when applied to the longer periods covered by intermediate-term forecasting. In the longer forecast, two methods of measurement are generally used: the long-term trend method and the correlation method. Correlation analysis requires data usually beyond the reach of the small businessman, but the long-term trend as determined by the least squares method may be useful. This method will not be taken up here, but an explanation of its use can be found in any introductory book on statistical methods.
Effect of Changing Market Factors
It must be reemphasized that a trend is determined from past data and from the total market as reflected in company sales. Insofar as these conditions remain in about the same state of balance, a projection of the trend into the future has some value; but the more dynamic these market factors are, the less reliable trend lines become.
The investigator must give careful thought to how changing market factors will affect his forecast. Although he cannot have precise knowledge of these factors, he must decide how influential they are likely to be and adjust his forecast accordingly.
Conclusions on Forecasting
The reliability of a forecast is always uncertain. Past performance is no guarantee of the future. The basic value in making a forecast is that it forces the buyer or seller to look at the future objectively. A forecast does not eliminate the need for value judgments, but it does require the forecaster to identify elements influencing the future. It may act as a damper on the buyer's unbounded faith in his own managerial ability.