Most businesses can be compared to other businesses within their industry, even those of a different size, by use of financial ratios. Some of the most common financial ratios for a closely held business include:
- Gross profit margin
- Profit Margin
- Inventory Turns
- Debt to Equity
- Average collection period (days receivables outstanding)
- Interest coverage
- Working Capital
- Acid test (quick ratio)
A business distributing $5 million of flour and sugar annually should be able to achieve similar ratios to a $20-million or $50-million business in the same space.
[quotesright]Focusing on one metric, such as day’s receivables outstanding can tell you about the business. [/quotesright] Most businesses extend credit to customers allowing the customer a certain number of days to pay the invoice. Say a review of a business’ receivables suggests the average customer is paying its bill in 45 days. If 45 days is standard for most businesses in the industry, there is probably little the business can do to speed up customer payments without upsetting them.
However, if the industry typically collects receivables in 35 days, then this business is offering an extra 10 days of free financing to its customers. [quotes]This means that 28 percent of its receivable or $28,000 for every $100,000 outstanding should have been collected already and available to the owner[/quotes] to either pay off bank financing, take early payment discounts from additional vendors or invest – all of which make the business more attractive.
If a financial ratio is below average, this may be a sign of inefficiency or waste. Beyond the additional capital required, the longer a receivable is outstanding, the more costs are incurred related to staff in collecting funds, printing and mailing second statements, sending letters, calling the customer, etc. [quotesright]These collection costs directly impact the bottom line and thus decreases the amount buyers are willing to pay for the business. [/quotesright]
Product and Industry Concentrations
[quotes]Too much of one thing can be bad, such as too much revenue from one customer. [/quotes] This can also be true of too much concentration or reliance on one product or one industry.
If a business sells a product and most of its customers are military related and there is a rumor or hint of a sequestration, or a change in military purchasing, buyers will be concerned and reflect this concern in their offer price. A business with a diverse clientele – some military, some health care, and some consumer goods – is perceived to have less risk. [quotes]Buyers assume that all three industries will not slow down at the same time[/quotes] or for same reason, thus making the risk of a significant decline in sales less likely.
[quotesright]Concentration can also be an issue in narrow product lineups. [/quotesright] Companies who build their business around selling one or a few products are susceptible to shifts in the industry, change in consumer attitude or new products supplanting current items. This very true in the medical field where emerging products are continually being released and others are being recalled. Offering multiple products is important for the business, even as one product seems to dominate, shifts in demand can happen quickly.
Coming Next Month: Train Tracks and Real Estate Leases”
- by Greg DeSimone - Beacon Equity Advisors, Inc.