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DECEMBER 16, 1999

SMART ANSWERS
By Karen E. Klein

What to Really Look For When Buying a Cash Business
Check the books for "phantom" employees, extra expenses, and other methods of distorting the financial picture


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Q: I am reviewing the profit/loss statement for a counter-style food establishment I wish to buy. I have figured out the percentage of expenses vs. income, but how do I know if these percentages are reasonable? Is there any source that would give me guidelines so I could know if this business is in good or bad shape?

---- J.W., Harrisburg, Pa.

A:There are several places where you can get average operating ratios for various types of businesses, including restaurants, which I'll detail below. First, some caveats about evaluating such businesses. Before you can assess this particular restaurant, you need to make sure you're getting a complete, accurate picture of its financial state. Insist that the current owner let you examine not only the income statement, but also the balance sheet, and daily, weekly, and monthly cash-flow statements. Then, you'll need to sit down — preferably with a certified business appraiser or a CPA familiar with restaurant operations — and recast these documents to get a true picture of the finances as they'd look like on the day you took over operations.

That's because the books of cash-based businesses — especially small, family-held operations — seldom accurately reflect cash flow. "Expenses will no doubt be inflated to mask the extra cash an owner will take from the business," says Gene Pepper, a business broker based in Glendale, Calif. For instance, a family business may have a "phantom" employee, perhaps a college-age son or daughter who is listed on the payroll but actually lives out of state. Or sometimes family members put in hours at a business but don't take salaries.

This is where the assessment process becomes tricky. You'll need the present owner's cooperation to find out what's really behind the numbers. "If they don't want to reveal that information, you ought to walk away," says Dean Duley, a certified business appraiser and licensed business broker based in Upland, Calif.

Once you've got a clear picture of the company's financials, look for a copy of the annual Restaurant Industry Operations report, produced by the National Restaurant Assn. (www.restaurant.org) and Deloitte & Touche, advises John M. Hamburger, a restaurant consultant and president of Franchise Times. "The report looks at average operating ratios among three or four different restaurant types, such as quick-service, mid-scale and fine dining or casual dining. Restaurant companies from all over the country submit this data." You can get the report from the association. You might also want to check out the business data listings of Robert Morris Associates (www.rmahq.org) and Dun & Bradstreet (www.dnb.com). The U.S. Small Business Administration (www.sba.gov) also has background information on restaurant operations.

Colin Gabriel, a Westport (Conn.) mergers and acquisitions expert and author of How to Sell Your Business — and Get What You Really Want, says that the average pretax profit margin (revenues less all expenses other than taxes) for U.S. businesses is in the vicinity of 9%. "I would point out that this is after providing for a reasonable salary for an owner/manager," Gabriel says. "I think you should aim for this norm, taking into account any interest expense for loans you might incur to buy the business. As a frame of reference, McDonald's earns aftertax profits equal to 14% of revenues."

Bring in a professional who knows the restaurant industry to help you evaluate this business, Duley advises. A full, written appraisal might cost at least $3,500. However, if you contract with an appraiser to simply review the materials the owner has given you and advise you on the prospects for this business, you'd be more likely to pay between $75 and $150 an hour, he says. The American Society of Appraisers (www.appraisers.org) has a directory of professionals.



Have a question about running your business? Ask our small-business experts. Send us an e-mail at smartanswers@businessweek.com, or write to Smart Answers, BW Online, 6th Floor, 2 Penn Plaza, New York, NY 10121. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally.

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