When buying a business, buyers are often presented with financial statements that appear strong, stable, and attractive. However, not all reported profits reflect the true, sustainable earnings of the business once ownership changes. In Australia, there are several common ways sellers unintentionally or deliberately inflate business valuations.
Understanding these practices allows buyers to normalise earnings, assess risk accurately, and avoid paying for profits that will not exist after settlement.
Business valuations are typically based on adjusted net profit or EBITDA. If this figure is overstated, the resulting valuation can be materially inflated. Buyers who rely solely on seller prepared adjustments without independent scrutiny risk overpaying.
The following sections outline common areas where profits are overstated and what buyers should carefully review during due diligence.
One of the most common valuation distortions occurs when the business operates from premises owned by the seller. In many cases, the business pays no rent or a rent that is significantly below market value.
This arrangement artificially inflates profitability. Buyers must normalise rent to a realistic market rate, as the business will need to pay commercial rent after the sale, unless the buyer also purchases the property.
Many owner operators do not pay themselves a formal wage, instead drawing profits from the business. While this may suit the seller, it does not reflect the cost structure a buyer will face.
If the buyer does not intend to work full time in the business, a market salary for a replacement manager or operator must be included as an expense when assessing profitability.
Sellers often add back expenses to inflate the EBITDA. Often described as owner perks, such as meals, travel, phone bills, or entertainment. While some of these may be discretionary, others are necessary for ongoing operations.
Buyers should carefully assess whether these costs will genuinely disappear post sale or whether they are required to maintain customer relationships, staff engagement, or operational effectiveness.
Review the Integrity of Stock
Sellers may be tempted to include old, un-sellable or sub-prime stock in the value of stock on hand. It's imperative that as a potential buyer you review the stock in person to check the the integrity of the stock during a purchase.
It is common for owners to exclude vehicle expenses, arguing that the vehicle is a personal benefit. However, if the business requires a vehicle for sales, site visits, deliveries, or management duties, this cost will continue.
When replacing the owner with a manager, buyers should include the cost of a company vehicle or vehicle allowance in the normalised expenses.
In some cases, business expenses such as electricity, water, internet, or insurance are shared across multiple businesses or properties owned by the seller. The business financials may only reflect a partial allocation or none at all.
Buyers should identify all shared costs and allocate a realistic portion to the business to reflect standalone operating conditions.
Some sellers minimise servicing and maintenance to reduce expenses and boost short term profitability. While this improves reported earnings, it often results in equipment being more worn than expected.
Buyers may face higher maintenance costs or capital replacement shortly after purchase. Normalising servicing expenses and assessing asset condition is essential to avoid unexpected costs.
Each of these adjustments may seem minor in isolation, but when combined they can materially inflate profitability. Because business valuations differ per industry and are often based on a multiple of earnings, small profit overstatements can translate into large valuation differences.
Buyers should always assess adjusted earnings using conservative and realistic assumptions rather than relying solely on seller provided add backs.
Inflated valuations are rarely the result of a single issue. More often, they arise from a collection of optimistic assumptions and omitted costs. A disciplined approach to normalising earnings is essential for buyers seeking long term success.
Buyers who understand how valuations can be inflated are far better equipped to negotiate fairly, manage risk, and acquire businesses that deliver genuine sustainable returns. If you're considering buying a business, contact the team at Lloyds Brokers for assistance.
