When you buy a business, you are buying assets of a company but in reality, you are buying a stream of earnings to be earned by those assets. The business assets are a means to make money but if they did not produce a cash flow, you would not be buying those assets.
The assets may have a liquidation value but price that you pay over and above that, the earning power of those assets is the goodwill
of the business.
In order to increase the value of the business, owners will have to have higher income. As a result, there is a possibility that the owner will claim many of the business expenses are personal and do not need to be continued on after he/she left the business and all the family members who are on the payroll are not really needed therefore should be added back in the normalized earnings. Often, owners will state that there is cash sales in the business and that is where the profits can be found.
In my opinion, if you cannot prove the cash sales then they do not exist. If the owner knows that there are cash sales and he knows that he is selling the business, why does he/she not come clean and deposit the cash in the business to prove what the actual sales are?
Many years ago, I had a retailer come to me and tell me that his profits were $300,000. All sales were done in cash and he reported very little to the government. He assumed that someone would shadow him in the store for 1 month and then extrapolate the cash sales and pay him $600,000 for the business which showed zero earnings. The sales and the profit were not supportable and could not be confirmed by a third party. My suggestion was that he run the store for 2 years and close it down.
That way, he earned what he was looking for and no one would take the risk of dealing with the government on the undisclosed cash, if in fact they really existed.
I had another case where someone bought a store and two months later were trying to sell it claiming that they did not like the hard work of working in a retail environment. He claimed that again, most of the sales were in cash. Red flags were flashing – he just bought a business, claimed it was all in cash and was liquidating it two months later. I am sure that he was told that there was cash in the business but after he purchased the business he discovered that really did not exist. It sounded like he was trying to minimize losses and the earning power of the business was not really what was being represented. Buyer beware.
Remember that if there are a lot of cash sales, there could be income taxes and sales taxes owed on those sales. If you purchase the shares of the business, you will become liable for any taxes or penalties and interest owed to the government on these sales. You may be indemnified by the seller of the business but remember, the government goes after the business, you then have to go after the seller. This could be a long process and you could be out of pocket for a long time unti you find the old owner. This assumes that you find the seller in a few years time when the audit is completed.