A company usually acquires another business mainly to build on weaknesses and strengths of the acquiring company. An acquisition should not be mistaken for a merger because a merger, though similar to an acquisition, is combining all interests of both the companies as one unit or business, while an acquisition may mean that the mother company will operate the new acquired business as an independent unit of its group.
Either way, an acquisition or a merger is usually transacted for betterment of the acquiring company by expediting the normal growth of the acquiring company. Why acquire a business? Many business owners want to know why businesses like to acquire other businesses instead of growing on their own steam – organically.
Let us try to understand why an acquisition may be the better option compared to a business growing organically by using an example. Let us say a business has total sales of 1 million dollars, where the cost of goods is just half of the total sales amount – 500 thousand dollars. This will leave the business with a gross profit of 500 thousand dollars.
In addition to the cost of goods, a business has many other expenses such as accounting fee, insurance, rentals and utility bills, which in this example will equal 350 thousand dollars. In addition, there will be drawings, such as salaries that equal 50 thousand dollars in this example. Therefore, the total expense budget will equal 400 thousand dollars.
This will leave the business with a total net profit of 100 thousand dollars. If the management of the business in this example sets a growth target of 10 percent, which is a very impressive growth target for any business, it would mean increasing sales by 10 percent, which is taking the total sales up to 1.1 million dollars. However, the additional increase of 10 percent in sales will cost the company an additional 50 thousand dollars according to this example.
This is the “organic” way of growing a business. However, if the business management were to identify a similar business in their niche with similar financial figures and acquires it, this is what the outcome will look like. After the acquisition the business now has total sales of 2 million dollars with an expense of 100 thousand dollars for cost of goods.
This will leave the business with a gross profit of 1million dollars. Now, because the businesses are run out of the same premises with the same staff expenses will not change much, nor will the costs of insurance or the cost of accounting. The drawings will not change either because the other owner is no longer present in the company.
How much will the business acquisition cost for a year’s profit? In the example in question we can set the acquisition cost on a yearly basis. So if the business is willing to pay 200 thousand dollars per year for additional profit, and project operations for 10 years, the business would be willing to pay 2 million dollars for the acquisition.
Growth of profit now, we add 200 thousand dollars to the previous 400 thousand expenses, which will take the total expenses up to 600 thousand dollars. This will leave the business with a total net profit of 1 million minus total expenses of 600 thousand dollars. This adds up to an amount of 400 thousand dollars! Thus an acquisition will actually grow a business by as much as 30 percent instead of the 10 percent projected organic growth.
Therefore, it is no wonder why so many businesses are choosing to acquire other businesses to increase their net profits instead of waiting for the business to grow organically over the years. Jack is freelancer writer of many finance sites and currently he is doing online Australian research on grants funding and grants for small business.