Starting a Business

8 Factors That Determine the Financial Health of a Business

8 Factors That Determine the Financial Health of a Business
Image credit: Pixabay

In their book, Start Your Own Business, the staff of Entrepreneur Media, Inc. guides you through the critical steps to starting a business, then supports you in surviving the first three years as a business owner. In this edited excerpts, the authors discuss all the financial factors you should investigate when you're considering buying an existing business.

So you've decided to purchase an existing business instead of starting from scratch and you've done some initial research to find out more about the business you're thinking of buying. What now? If the business still looks promising after your preliminary analysis, your next step is to have your acquisition team (your accountant, attorney and banker) should start examining the business’s potential returns and its asking price. Whatever method you use to determine the fair market price of the business, your assessment of the business’s value should take into account such issues as the business’s financial health, earnings history, growth potential, and intangible assets (for example, brand name and market position).

To get an idea of the company’s anticipated returns and future financial needs, ask the business owner and/or accountant to show you projected financial statements for the business. Balance sheets, income statements, cash flow statements, footnotes and tax returns for the past three years are all key indicators of a business’s health. These documents will help you do some financial analyses that will spotlight any underlying problems and also provide a closer look at a wide range of less tangible information.

Among other issues, you should focus on the following:

Excessive or insufficient inventory.

If the business is based on a product rather than a service, take careful stock of its inventory. First-time business buyers are often seduced by inventory, but it can be a trap. Excessive inventory may be obsolete or may soon become so; it also costs money to store and insure. Excess inventory can also mean there are a lot of dissatisfied customers who are experiencing lags between their orders and final delivery or are returning items they aren’t happy with.

The lowest level of inventory the business can carry.

Determine this, then have the seller agree to reduce stock to that level by the date you take over the company. Also add a clause to the purchase agreement specifying that you're buying only the inventory that's current and saleable.

Accounts receivable.

Uncollected receivables stunt a business’s growth and could require unanticipated bank loans. Look carefully at indicators such as accounts receivable turnover, credit policies, cash collection schedules and the aging of receivables.

Net income.

Use a series of net income ratios to gain a better look at a business’s bottom line. For instance, the ratio of gross profit to net sales can be used to determine whether the company’s profit margin is in line with that of similar businesses. Likewise, the ratio of net income to net worth, when considered together with projected increases in interest costs, total purchase price and similar factors, can show whether you would earn a reasonable return. Finally, the ratio of net income to total assets is a strong indicator of whether the company is getting a favorable rate of return on assets. Your accountant can help you assess all these ratios. As they do so, be sure to determine whether the profit figures have been disclosed before or after taxes and the amount of returns the current owner is getting from the business. Also assess how much of the expenses would stay the same, increase, or decrease under your management.

Working capital.

Working capital is defined as current assets less current liabilities. Without sufficient working capital, a business can’t stay afloat—so one key computation is the ratio of net sales to net working capital. This measures how efficiently the working capital is being used to achieve business objectives.

Sales activity.

Sales figures may appear rosier than they really are. When studying the rate of growth in sales and earnings, read between the lines to tell if the growth rate is due to increased sales volume or higher prices. Also examine the overall marketplace. If the market seems to be mature, sales may be static—and that might be why the seller's trying to unload the company.

Fixed assets.

If your analysis suggests the business has invested too much money in fixed assets, such as the plant property and equipment, make sure you know why. Unused equipment could indicate that demand is declining or that the business owner miscalculated manufacturing requirements.

Operating environment.

Take time to understand the business’s operating environment and corporate culture. If the business depends on overseas clients or suppliers, for example, examine the short- and long-term political environment of the countries involved. Look at the business in light of consumer or economic trends; for example, if you're considering a store that sells products based on a fad like Crocs, will that client base still be intact five or 10 years later? Or if the company relies on just a few major clients, can you be sure they'll stay with you after the deal is closed?

Edition: October 2016

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