Finding Optimal Business Investments - Financial Statement Analysis Methodology - Part 2.
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In the previous post, we highlighted 3 areas of concern that determined the financial strength of a prospective business acquisition. Respectively, Profitability, Solvency, and Rate of Return give a high-level view of the financial prospects of a business.
However, a further, more detailed review of the financial statements is necessary to confirm the story revealed in the financial ratios and to pinpoint problem areas that would require action, and the cost to rectify potential conflicts.
As a addendum to the previous post, we turn our attention to the 2 main financial statements – namely the income statement and the balance sheet – to determine whether or not the initial story revealed by our initial financial ratio analysis is in fact true. We review here a few main accounts that need to be reviewed further to give additional valuable information upon which to assess the prospects of the business. Following we look at some balance sheet items that need a further, closer look.
Balance Sheet
Assets
- Cash
As we proceed down the list of assets, no doubt the most important of all is cash. Cash can be monitored and assessed on it’s own basis, but it’s also valuable to compare specific asset balances against those of similar businesses within the industry and market in which the business operates.
We review the cash balance first to determine whether or not liquidity ratios and working capital requirements are being met. One should ask if the cash balance ever goes into a negative position, and if so, why? Are there major fluctuations in the balance through the year attributable to circumstances not related to owner discretionary spending? Such negative variations may expose a problem with accounts receivable collection or over spending on costs.
What we want to see is a consistent increase in cash over time. Assuming sales asre constant, and price points provide a profitability level in line with strategic goals, cash should be increasing in value. Any negative seasonal fluctuations must be accounted for, and if recognized, then the assumed cash balance can be adjusted accordingly. However, the business should be providing a strong cash return, and if not, the question of why must be answered. Correcting issues related to the cash account must be weighed against the cost of correcting such issues. Assuming that the owner finances the acquisition, s/he should calculate the time it will take to recoup that equity infusion/repay that debt. If additional cash is needed to finance a business transition, that will increase the required point at which the owner breaks even on his/her investment.
- Accounts Receivable
The main concern with accounts receivable is that they are not being collected on time, thereby eroding working capital and ratios and the cash balance. Optimally, the accounts receivable balance remains low, with no amounts over the 30 day period. Some customers, however, will manage their own cash by only paying invoices 60 days after receipt. Although this remains a practice in various industries, such a practice can hamper cash flow requirements for small business owners who must finance costs to produce and provide for other customers while waiting for payment.
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Related to accounts receivable is the amount of accounts receivable write-offs. THE expense section of the income statement will show an amount for “Bad Debt Expense”, which is essentially an accounts receivable amount deemed uncollectible.
An increasing bad debt expense amount suggests either an incapable collection process or customers unwilling or incapable of paying. If the former, new staffing or procedures will be required in addition to internal audit procedures to monitor ongoing accounts receivable collection. If the latter, then there may need to be change in either product offerings or target markets to position the business to provide to loyal paying customers.
- Capital Assets
The main reason to look at the capital assets section is to see if ownership is investing in capital assets correctly to facilitate growth. A large cash balance combined with overworked employees may signal a need to invest in additional capital resources to accommodate increased business.
Contrastingly, capital asset usage should be assessed to find out if they are being used well to contribute to overall growth. If the assets are sitting idle or are not being used a lot, then it’s possible that the cost of maintaining them may outweigh their financial contribution to the business.
The prospective owner must also ask “What is the rate of return if we were to purchase capital assets and add another work shift. Can we reasonable expect a sufficient rate of return on this investment”. Forecasting questions come up when assessing capital assets, because investments in assets need to be planned in order to time their delivery and contribution with business seasonality levels.
Liabilities
- Accounts payable
Intuitively speaking, the prospective owner wants to see payment of account payable in an organized fashion. Payment of accounts payable suggests good cash flow management and a sustained positive level of credibility within the industry. If the accounts payable are dangerously increasing in level over time in relation to sales, then – like cash – this may reveal price points lower than what they need to be, insufficient cash flows to finance accounts payable, or unorganized accounts payable procedures that now need to be formalized and monitored.
- Long-term debt
Depending on the proclivities of the prospective owner, debt can be a good thing or a bad thing. As we stated in our previous article on financial statement analysis, the weighted average cost of capital is minimized with a mix of equity and debt financing. The level of debt carried by the business therefore becomes a strategic decision that an increase cash flow and facilitate overall growth.
The prospective owner needs to ask “Do we have sufficient cash flows to service the debt, and is the debt providing the required benefits for which it was secured in the first place?” Debt should be taken to increase production, secure market share, or finance expansion that can be sustained after the debt is paid off. Debt taken on to provide working capital, finance accounts payable, or for any other “current” problem is a red flag which must give the prospective owner pause and compel him/her to unearth underlying problems giving rise to this need of capital.
These are just a few of the balance sheet items that provide a more detailed picture of the viability of a prospective business acquisition. Any problems in the balance sheet are normally due to revenue and/or expense issues, or mismanagement of company resources once the income has been generated.
Nicholas Kilpatrick is a partner at the accounting firm of Burgess Kilpatrick in Vancouver, B.C. He concentrates his practice on assisting business owners with accounting services, tax and estate planning and overall business development.
