Saturday, May 1, 2010

Allowances for Capital Expenditures

There is little doubt that our industry is capital intensive, requiring constant replacement and upgrades of equipment and software.

When valuing a business it is important that the business you anticipate buying (or the one you are selling), is able to afford three things:

(1) Pay you a "living salary" according to a formula outlined by Larry Hunt and myself.

(2) Be able to fund and support various capital expenditures during the 2-4 years the business is being purchased or sold. This is the specific reason why we do not include "Depreciation" or "Interest" payments as part of owner's cash flow or owner's compensation. For most small businesses, these are ordinary and very real expenses of a small business. They are not merely paper transactions that can be dismissed with accounting tricks and terms.

(3) All the while, the business must also be able to consistently generate enough excess earnings to pay the seller his asking price. Yes, that's quite a task, and that's why most businesses are worth very little and while many more simply close their doors.

To quote one source, "You must deduct appropriate amounts from the "owner's benefits" number in order to determine both the true value of the business as well as its ability to fund future expenditures."

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