Finding Optimal Business Investments - Financial Statements Analysis Methodology - Part 1.
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For business owners seeking to build business empires through acquisitions, being able to quickly and accurately assess the prospects of a business venture is a skill learned only over time and with extensive practice. With so many options available in which to invest financial resources, the exercise of short-listing potential business acquisitions has become a coveted skill among aspiring and established entrepreneurs alike.
Those successful in the art invariably combine organic growth with the purchase of business units that offer complementary products and/or services, and which take advantage of economies of scale and shared business processes to optimize value and profit. They determine their desired return on investment (ROI), seek out opportunities that can provide that return considering the resources they have to commit, and then drill down further to ascertain economic fit and expose danger points that render the prospect detrimental to the execution of the strategic plan and potentially harmful to the owners’ resource base.
In studying successful entrepreneurs, one of the tenets of successful business ownership seems to be the ability to identify and place valuable resources in the right places. For example, as a group they all seem to sing the same chorus of surrounding themselves with people smarter than themselves . A strong network of human resources is found in any company with a fundamentally strong business model, and it’s the people of the operation that formulate, design and execute strategies to maintain and grow new models to sustain profitability and longevity.
Having the adroit capacity to correctly allocate financial resources in the right locations seems also to be a prerequisite for long-term success. Depending on the economic state of affairs in the region(s) a business operates in, going on an acquisition spree may not be the optimal usage of resources if, for example, inflation is high and the price of goods is stretching beyond the affordability level of the target market. Deferring an acquisition that looks strategically viable on paper and instead investing internally to shelter against interest rate risk may therefore be the best strategic alternative of the day. Smart entrepreneurs know when to play defense with their resources, realizing that a defensive posture at times allows for the accumulation of resources that funds future growth and possibly averts disaster.
In the context of finding optimal investments on which to risk their precious resources, following is a short list of the main criteria that can expose the ROI that successful entrepreneurs look for:
- Profitability
- Solvency
- Return on Investment (ROI)
- Profitability
No business can survive without eventually being profitable, and current profitability of course plays an instrumental part in determining the viability of a potential acquisition. However, as we know, current profitability can be a smokescreen shielding passive inquirers to problems lurking beneath. Consider IBM in the early 1990’s or Kodak. Executives at both companies neglected to recognize future trends and prepare their respective companies for future growth in these areas. IBM eventually invested heavily and worked hard to become viable again and eventually become a leader in cloud and business consulting services. Kodak, however, was slower in responding and no longer exists due to its’ inability to evolve. Apple Inc. purportedly has various products and services in various stages of development that will be released over the next 4 years, thereby guaranteeing sustainable levels of profitability over that time horizon.
At the very least , successful entrepreneurs look for businesses that have the capacity to profit in the future as well as in the present.
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- Solvency
Profitability can easily lead to bankruptcy if the cash flow lags behind too much. A simple review of the accounts receivable balance and collection processes can determine whether or not this is a problem, but also important is to assess the target market to gauge if any collection problem can be fixed, or if there are underlying situations beyond the control of management or processes that make the flow of cash flow inelastic.
The collection of money, after all, is what predicates value and credibility among financial institutions and shareholders/investors, and no level of profitability will shield this unfortunate problem. Successful entrepreneurs always ensure that they get paid, and protect their business from those who don’t respect them enough to pay for their products and services.
No business maintains a zero balance in accounts receivable, and we’re all going to be caught eventually with an uncollectible receivable. The main task here, however, is to not get caught with a business acquisition containing an unfixable collection problem.
- Return in Investment (ROI)
As mentioned previously, Return on Investment is the initial benchmark used by prospective owners to assess the value of the potential acquisition. However, notice that the main drivers of ROI are 1 and 2; ROI suffers if either one of them is absent, or low.
To truly analyze ROI requires a forecast of future strategic models, business environments, trends, target markets and personnel to determine if the company is positioned well enough to remain a viable operation 5 and 10 years into the future, and if it’s not currently viable , what is the cost to making it viable and will those costs provide an ROI high enough to warrant the purchase of it?
These are the 3 main areas of financial statement analysis that, when reviewed, can give the prospective owner a balanced view of the chances of a prospective business acquisition. How these 3 areas are analyzed requires a more detailed review of the income statement and balance sheet, which we’ll cover in the next article.
Nicholas Kilpatrick is a partner at the accounting firm of Burgess Kilpatrick in Vancouver, B.C. He concentrates his practice on business development - assisting business owners with accounting services, tax and estate planning and overall business development.
