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Buying an existing business: Examining the financials
 Before
you make a commitment to buying a business, ask to see five years'
worth of company financial statements. Your accountant can be of
great help as you check these records. Many experts recommend auditing
the books rather than accepting a set of financial statements prepared
by the current owner.
Besides tax returns and sales reports, you'll want
to examine profit-and-loss statements, cash-flow statements, inventory
turnover, accounts receivables and operating budgets. The company's
business practices and accounting methods should also be reviewed.
Create your own profit projections using current market conditions
and the financial information you gathered from the company.
When examining the financial statements, banks are
known to use upwards of 150 financial ratios to examine the health
of the business. So, for the most part, you will rely on your accountant
to perform ratio analysis. You should at least learn, however, the
definition of the current, quick, days payable, days receivable,
inventory turnover, return of assets (ROA) and return on investment
(ROI) ratios.
Current and quick ratios address the financial liquidity
of the business. They reflect the ability to liquidate current assets
to pay off current liabilities. We are not assuming you will need
to liquidate if the business is solvent, but these ratios reflect
how well you could meet unexpected expenses without compromising
fixed assets. Days payable and days receivable also reflect liquidity,
and tell you how long the seller normally takes to pay off accounts
payable, and how long it takes the seller to collect on accounts
receivable. Assuming this is not a "cash-only" business, 30 days
is the ideal average for payables and receivables. The exception
would be where early payment of a payable results in a discount
to you.
For the product-based business, inventory turnover
reflects the number of times the average inventory on hand is sold
in a year. For example, an inventory ratio of 5.5 indicates the
business sells its average inventory 5.5 times per year. The higher
the ratio, the more times the product is sold, and the more sales
you generate. You will need to compare the seller's performance
with industry averages in order to arrive at assumptions about whether
the business is prospering.
Return of assets and return on investment are performance
ratios of investment. They demonstrate how well the seller is using
business resources to generate profits. Return of assets shows how
well company assets are used to generate profits. Return on investment
shows how well capital investment is used to generate profits. As
in all other ratio analysis, the seller's performance should be
compared to industry performance.
The banking industry generates annual results of
ratios
for hundreds of industries, which are published in many different
directories. Commercial lenders and many CPA firms have these publications,
as well as many public libraries.
Ratio performance is divided into three categories:
the upper quartile (25 percent), the middle half (50 percent), and
the lower quartile (25 percent) of performers in each industry.
Ideally, the seller's ratios would be in the upper quartile, if
not the upper range of the middle (average) performers.
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