Are you ready for a crash course?
If you’re in the market to buy a business, a major part of your acquisition will be carefully reviewing the finest financial details of your target company.
Profit and loss (P&L) statements (1), cash flow statements (2), and balance sheets (3) are all critical documents you’ll want to review when vetting a company up for sale.
Each tells an important financial story and provides vital stats on a business’s health, giving you a sense of its true value and longevity.
These three documents are a core piece of your due diligence. The first part of this article gave more detail about these documents.
Still, you’ll also want more information about their tax filings and some of the more important elements of the balance sheet. This topic was dealt with in the second part of this article.
In the third part of this article we looked at the various financial terms in the P&L, and the relationship between various of the numbers in the P&L and balance.
In the fourth and last part of this series of articles an explanation how to calculate key indicators (ratios), and what red flags you should look for.
Calculate Financial Ratios
Financial ratios are a valuable tool for evaluating a business's financial health. Here are some of the most important ratios to calculate:
Gross Profit Margin: Measures the business's profitability by comparing its gross profit to its revenue. A higher gross profit margin indicates better profitability.
Net Profit Margin: Measures the business's profitability by comparing its net income to its revenue. A higher net profit margin indicates better profitability.
Current Ratio: Measures the business's ability to pay its short-term liabilities by comparing its current assets to its current liabilities. A higher current ratio indicates better liquidity.
Debt-to-Equity Ratio: Measures the business's leverage by comparing its total debt to its total equity. A lower debt-to-equity ratio indicates better financial stability.
Inventory Turnover Ratio: Measures the business's efficiency by comparing its cost of goods sold to its average inventory. A higher inventory turnover ratio indicates better efficiency.
Look for Red Flags
When reviewing small business financials, it’s important to look for red flags that may indicate potential issues with the business. Here are some common red flags to watch out for:
High Debt Levels: If the business has a high level of debt compared to its equity, it may indicate financial instability and difficulty servicing debt obligations.
Declining Revenue or Profitability: If the business has experienced a decline in revenue or profitability over time, it could suggest underlying issues with the business model or market conditions.
Poor Cash Flow: If the business has consistently negative cashflow or struggles to pay its bills on time, it might indicate underlying issues with its operations or management.
Overvalued Inventory: If the business has an inventory valuation significantly higher than its cost of goods sold, there might be an overstocking issue or trouble selling inventory.
Late Tax Payments: If the business has a history of late tax payments, it may indicate poor financial management or a lack of cashflow.
Ask Questions and Seek Expert Advice
It’s important to ask questions and seek expert advice when reviewing small business financials. Ask the seller for clarification on any issues or discrepancies that you identify. You may also want to ask for advice from a business broker, accountant, or another financial professional who can provide additional insights and guidance.
Reviewing small business financials is an essential step in the process of purchasing a business. By obtaining and analyzing the necessary financial documents, calculating key financial ratios, and looking for red flags, prospective buyers can fully understand the business's financial health and decide whether to proceed with the purchase. Remember to seek expert advice and ask questions to ensure a thorough review of the financials.
This article is reposted, with permission, from DealStream.
May 1, 2023