Red Flags A Warning Sign

Potential buyers of businesses often look for red flags, or warning signs concerning the characteristics of a given business for sale. While virtually every business has negative traits, a red flag indicates a significant and unusual risk that a business may not perform up to the buyer’s expectations after the sale. An experienced business broker should incorporate this risk into the asking price, especially if the negative trait that triggers the risk is permanent in nature and beyond the control of the buyer. Some businesses with red flag warning signals may only be appropriate for buyers familiar with the industry in which the business operates or for buyers comfortable with turnaround situations. By identifying common red flags, business owners will be better equipped to deal with questions and concerns from potential buyers.

Red Flag: Selling Too Soon

Perhaps the most common red flag of small businesses for sale is when the business is put for sale after a very short period of ownership (less than 12 months). Whether the owner is selling after starting the business or just after purchasing the business (common among business ‘flippers’), most buyers view a seller’s decision to sell so quickly with great suspicion. Buyers justifiably wonder whether the true reason for such a quick sale is because the business is unprofitable, difficult to run, or subject to a large amount of competition. In reality, many business owners have legitimate reasons to sell their business after a short period of ownership including a death in the family, divorce, sickness, or a need to move. The business broker should clarify and explain these reasons to prospective buyers in order to lessen the negative impact of this potential red flag.

Red Flag: Declining Profitability

Declining profits – or adjusted owner benefit – over a sustained period of time (two years or more) is a major red flag for many buyers of businesses.
Buyers generally examine the last three years of a company’s financials (such as tax returns or profit and loss statements) in order to look at the historical trend of gross sales and profits.
If both sales and profits are consistently and significantly declining over a 2-3 year time period, it probably signals that the business is facing competition that it did not have in the past or has negative internal issues (such as poor customer service or lousy management).
A business with stable sales over time yet consistently declining profits means that its operating margins (or return on sales) are declining.
This signals that the business has rising labor, supply, or occupancy costs which are not being absorbed by its customers.
When selling a business with declining sales, profits, or operating margins, a professional business broker prices the business appropriately so that the asking price is reasonable enough to entice buyers comfortable with a turnaround situation.
Further, the business broker must explore why exactly the financials show declining sales and profits.
When temporary in nature or due to non-recurring factors, the decline may be excused to some extent with minimal impact on the valuation.
No matter the reasoning, the decline must be clearly disclosed to potential buyers so that they are not surprised later on in the formal due diligence process when such problems are inevitably discovered.
Often the reason for a business with declining sales and profits is an unmotivated owner with one foot out the door.
Such a business is often still saleable (with a reduced valuation) to a buyer who plans to take on an active role and grow the business.

Red Flag: Growing Accounts Receivable

A disproportionally large or increasing level of accounts receivable (A/R) – or uncollected but billed revenue for products sold or services rendered – is a sure sign that a business is having problems collecting money from its customers. For many buyers this poses a major warning sign that the customer base is not credit worthy and that the business has poor pricing power or relations with its customers. Some A/R in a business within certain industries (such as construction and healthcare) is typical and is not by itself a red flag. But the level of A/R should still not constitute more than 60 days of a company’s revenue, and it should not be increasing over time as a proportion of the overall sales. Otherwise, the valuation will suffer and a business owner is better off in trying to reduce their A/R by getting a handle on late payors prior to selling.

Red Flag: Low Inventory Turnover

For businesses in retail-related industries which carry a significant amount of inventory (or goods and products ready to sell along with required raw materials), the speed with which a business turns over its inventory in any given period is the inventory turnover ratio. This key financial metric measures a company’s efficient use of its resources as well as the level of customer demand. Businesses with an unfavorable inventory ratio of more than 3-4 months may serve as a red flag that the company has inefficient purchasing, carries a high amount of unwanted inventory, or has a subpar marketing brand which is not well received by its customers. Business owners in retail-related industries should always pay attention to their inventory turnover ratio and should increase it as much as possible before it becomes a red flag for potential buyers.

Some buyers may stay away from businesses with a major red flag such as the owner selling too soon, declining profitability, or unflattering key financial metrics. Other buyers – often with more industry-knowledge and business experience – still consider purchasing businesses with red flags as they believe the uncertainties and problems are fixable and do not pose a danger to the long term value of the business.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.