📈 Quick Sniff Test for Business Acquisitions

INTRO

It’s Michael.

In today’s issue:

• THE WEEKLY: 📈 Quick Sniff Test for Business Acquisitions

• BEST RESOURCES: IRS Tax Returns + LBO Model

Let me know what you think. Drop a reply or click the poll at the end of this email.

THE WEEKLY

We all have the same 24 hours. 

As an ambitious business buyer, time allocation is critical. 

There are a million things to do. 

There are thousands of deals to look at.

But you don’t have time to do full financial due diligence on thousands of deals.

You need to decide which deals are worth spending time and money on.

What you can do is what I call a ‘sniff test’. There are 3 steps:

1. Look at industry averages, compare to the target’s numbers, and calculate expense ratios

2. Create a financial forecast for the target based on average expenses ratios

3. Calculate debt service coverage ratio

Step 1: Look at the industry averages, compare it to the target, and calculate expense ratios.

The IRS publishes tax return numbers for every industry. It ain’t perfect, but you can back into what the average player is earning per year.

Here’s an example for a business in “Printing and related support activities.”

Let’s say you’re looking at a business with $850k in revenue and $212k in cash flow. Without comparing it to industry averages, all you know is that the target’s cash flow as a % of revenue is 24.94%. But if you compare it to industry averages, then you can see that the target is way above average 👇️ 

Now, calculate your expense ratios based on industry averages 👇️ 

Step 2: Create a financial forecast for the target based on average expenses ratios

1. Use the target’s revenue as a starting point

2. Back into cash flow by taking the expense ratios from Step 1 and plug into the financial forecast

3. Decide how much leverage you will use to buy the business. In this example, I would finance 90% of the deal through a SBA loan (10.75% rate, 10-year term).

Here’s a condensed example.

Step 3: Calculate debt service coverage ratio

Finally, you want to calculate the debt service coverage ratio.

Formula = Free Cash Flow Available for Debt Paydown / Debt Paydown

Keep in mind:

• 1.25x - 1.50x → Minimum for lenders

• 1.75x - 2.50x → Strong DSCR

• 3.00x+ → Excellent DSCR

BEST RESOURCES

• IRS Tax Return Data

  • Corporations

  • Partnerships

  • Sole Proprietors

  • S-Corporations

• LBO Model (reply “LBO” to this email if you want it. I’ll share it with you, hop on a call, and show you how to update the model. For free.)

THAT'S A WRAP

How I Can Help 💰️ 

I’m the owner of Divergent CPA, an advisory firm that helps business operators and business buyers with:

• Strategic tax & accounting

• Dealmaking

If you’re interested in a strategy call & demo, book a free consult with me 👇 Note: We’re keeping things small intentionally, like a boutique. So, don’t wait.