The Proof is in the Numbers
Recently, I was working with a client looking at a potential investment. As I was pouring over the diligence, I noticed some interesting and unfortunate trends. By using quick and simple ratio analysis, I was able to determine that the business was not as healthy as initially thought, nor as the sellers portrayed. A few simple calculations saved my client significant purchase price dollars and buyer’s remorse once they acquired a business in serious trouble.
I think it is important that all business people (including lawyers) be able to understand, digest and interpret basic financial statements. If you are not familiar, I have set forth below a few key financial ratios that you can use to assess the financial health of a business:
- Quick Ratio (Acid Test): Cash+Marketable Securities+Receivables / Current Liabilities. This tests the short term stability of the company by determining the extent to which the company can pay its current liabilities without relying on the sale of inventory. This test is a bit more precise that the Current Ratio because it excludes inventory and focuses on liquid assets.
- Debt to Equity Ratio: Total Liabilities / Net Worth. This test quantifies the relationship between the capital invested by owners and the funds provided by creditors. The higher the ratio, the greater the risk to a current or future creditor. However, an extremely low ratio may indicate that the company is too conservative and not realizing its potential.
- Gross Margin Ratio: Gross Profit / Net Sales. This test indicates how well the company can generate a return at the gross profit level, by addressing three areas — inventory control, pricing and production efficiency.
- Return on Investment Ratio (ROI): Net Profit before Tax / Net Worth. This is the percentage of return on funds invested in the business by its owners and tells the owner whether or not all the effort put into the business has been worthwhile. It is used to compare investment in the company against other investment opportunities.
- Accounts Receivable Turnover: Total Net Sales / Accounts Receivable. This ratio shows the number of times accounts receivable are paid and reestablished during the accounting period. The higher the turnover, the faster the business is collecting its receivables and the more cash it has on hand.
- Break Even Analysis: While not a true financial ratio, a break even analysis is a very important tool for business people. A company breaks even when its total revenue equals its total expenses. At the break even point, no profit has been made, nor have any losses been incurred, but the lower limit of profitability has been identified.
There are many other ratios and financial tests that can drill into other specific areas. However, the tests shown above will provide a good start when evaluating the financial health of a business.