Evaluating a business’s financial health is critical to making a sound investment. Here’s how to dig into the numbers and uncover the complete picture.
Examine Financial Statements
Request at least three years of financial records, including:
- Income Statements: Look for consistent revenue and profitability. Businesses with fluctuating income may indicate market instability or operational inefficiencies.
- Balance Sheets: Assess assets, liabilities, and equity to gauge overall financial stability.
- Cash Flow Statements: Ensure the business generates enough cash to cover expenses and investments.
- Tax Returns: Something is wrong if the tax returns don’t match the income statements!
Did you know that over 50% of small businesses fail due to cash flow problems? A healthy cash flow is often a better indicator of business viability than profit alone. More on that in another article.
Identify Hidden Liabilities
Not all financial risks are immediately obvious. Investigate:
- Debt Obligations: Review loan agreements for terms that could impact future operations.
- Pending Lawsuits: Legal issues can lead to reputational damage and financial strain.
- Contractual Commitments: Leases, supplier agreements, and vendor contracts may have unfavorable clauses that could limit flexibility.
Analyze Key Metrics
Key performance indicators (KPIs) provide a snapshot of a business’s operational efficiency. Focus on:
- Profit Margins: Healthy margins indicate operational efficiency. For benchmarks, less than 10% = bad, 10-15% is good, and over 15% means they are good or underinvesting in growth.
- Customer Retention: High retention rates signify customer loyalty and stable revenue streams.
- Customer Concentration: Ensure that no one customer accounts for more than 15% of total revenues. A high concentration of customers means that if one customer churns, you could be facing financial distress.
- Inventory Turnover: A low turnover rate may suggest overstocking or declining demand for retail or manufacturing businesses.
Leverage Forensic CPAs that Specialize in Business Acquisitions
Forensic accountants can uncover red flags in financial documents, ensuring a thorough vetting process. They also provide QofE studies or quality of earnings to ensure that the revenues match the actual invoices billed to customers. Investing in this step is critical. A study by the International Business Brokers Association found that 30% of failed deals stemmed from overlooked financial discrepancies.
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