What actually decides how much business you can buy

Most people arrive at a number for what they can afford by taking what they think their house is worth, adding their savings, and multiplying by something. It is usually about twice the real answer, and the gap is made of two things nobody mentions until later.

The first is that a lender lends against a proportion of a property's value, not against the value, so the equity you can actually release is smaller than the equity you have. The second is that the business itself has to pass a test that has nothing to do with your deposit.

Where the money in a purchase comes from

Four sources, and they are not interchangeable. Each has a different cost and a different limit, and the mix decides both what you can buy and what happens to you afterwards.

There is a fifth line that is not a source at all and is the one most often raided: the working capital the business needs to keep trading from the day you own it. More on that below, because spending it is the most common way a funded purchase still fails.

Your share, and why it is smaller than it looks

Take a house worth $950,000 with $600,000 still owing. Most people call that $350,000 of equity, and in the ordinary sense it is. It is not what you can release.

A lender will lend to a proportion of the property's value. At 80%, that is $760,000. The mortgage comes off that ceiling rather than off the value, which leaves $160,000. Not $350,000. The difference is the twenty per cent of the house nobody will lend against, and it is $190,000 of the number in your head.

Releasing that $160,000 is a new home loan, and it costs about $12,964 a year to carry over twenty five years. That repayment does not pause if the business has a bad quarter, and it is secured against the place you live. It belongs in the decision as a cost rather than as free money.

What a lender puts in

A commercial lender funds a share of the price and expects you to fund the rest. Where that share sits depends on the business, the security and what else is behind the deal, and it is commonly well short of the whole thing.

The arithmetic runs backwards from your deposit. If a lender funds 60%, your $330,000 has to cover the other 40%, which puts the price at $825,000. Nothing about that number is a judgement on the business. It is division.

The test the business has to pass on its own

Separately, and regardless of your deposit, the business has to earn enough to carry the debt used to buy it. Earnings first get reduced by what it costs to hire someone to do the job you are about to do, because somebody has to do it and it may not always be you.

On a business earning $420,000 with a market salary of $130,000 for the role, that leaves $290,000. Tested at a cover ratio and at a rate above the one you would be quoted, $290,000 supports a facility that would take the price to about $1,315,000.

Why a better business may not help

Two ceilings, and the lower one is the answer. Here the deposit stops you at $825,000 and the earnings would have carried $1,315,000, so the deposit is what binds.

Which produces the result that surprises people most, and it is the single most useful thing on this page.

A buyer in this position can spend six months hunting for a stronger business and end up able to buy exactly what they could before. The search was aimed at the wrong constraint. Knowing which of the two is holding you back changes what you should be doing with your time, and it takes an afternoon to work out.

It runs the other way too. A buyer with plenty of cash and a modest target is limited by the earnings, and for them a better business is precisely the answer. Same arithmetic, opposite advice.

The money you must not spend

Holding $80,000 back reduced what the buyer could pay from $1,025,000 to $825,000. That is a real cost and it is tempting to skip, particularly late in a negotiation when $80,000 is the gap between an offer and an acceptance.

It is also the most reliable way to own a business you cannot run. From day one the stock has to be replaced, the wages have to be paid, and the invoices you issue will not be paid for another month or two. None of that waits for the business to settle in, and a buyer who has spent the reserve on the price is borrowing at the worst possible moment, from a position of obvious need.

What the file needs

To work this properly rather than approximately, six things.

• Cash you are genuinely willing to commit, which is usually less than the balance of the account.
• The property's current value and the exact mortgage balance, not the purchase price and the original loan.
• The target's earnings rebuilt rather than accepted, because the price is built on a figure the vendor prepared.
• A market wage for the role you will perform, sourced rather than guessed.
• The working capital the business needs in a normal month, taken from its own accounts rather than estimated.
• Every existing commitment you already carry, because the new debt is tested on top of them.

Get those six right and the answer is arithmetic. Get the third one wrong and everything downstream of it is wrong too, which is why the earnings are the part worth paying someone to test.

The acronyms, in one place

What we can and cannot tell you

Andorra Advisory Group does not arrange credit and is not a credit representative. We build the analysis and the documents. Where a client wants the finance arranged as well, that is a referral to The Lending Lab Pty Ltd, a separate broking business, disclosed in writing at engagement. Our fee is fixed and payable regardless of whether finance is approved or what the analysis concludes.

We are not business agents and we do not act for sellers. We give no taxation advice, no legal advice and no financial product advice, and we do not tell you what to pay. Every threshold here is a level commonly seen and every lender sets its own.

What we do is the number the price has to be built on: the earnings the business actually produces, tested against the debt it would have to carry. What you pay is your decision, and your solicitor's and your accountant's. Our figure tells everyone what they are pricing.

General information only. Not credit advice, not a credit assessment, and not an offer of finance. Lending decisions rest with the lender and depend on your circumstances and their criteria.