Financial ratios are a way to evaluate the performance of a business and identify potential problems. It is imperative to consider the financial ratios of a subject business when undertaking due diligence, as ratios can highlight problems within a business and can assist with identifying risk factors.
Financial ratios are used to examine different aspects of a company’s performance and to show how the company stacks up within a particular industry or region.
Financial ratios vary from industry to industry, so comparing your ratio to benchmarks within the particular industry will give you a better idea of how the business that you are undertaking due diligence on stacks up.
Below are some of the key financial ratios that should be examined as part of every due diligence exercise.
Gross Profit Margin Ratio
A gross profit margin ratio shows the proportion of profit for each sales dollar before expenses. The acceptable gross profit margin ratio varies from industry to industry, but in general, the higher the margin the better.
Return on Investment (ROI)
ROI shows how efficient your business is at generating profit from the original investment (equity) from the owners or shareholders. For business buyers, they should be conscious of the likely ROI of the business should they proceed to purchase by considering the likely future profitability of the business in conjunction with the sales price that they will pay to purchase the business, noting here that lenders will also use similar metrics to approve or deny any finance applications that you may need to submit to complete the acquisition.
Accounts Receivable Ratio
This ratio measures the business’ effectiveness at collecting debts from its customers. A low ratio may indicate that the business has issues with slow paying customers that should be examined more closely as part of the due diligence process.
Accounts Payable Turnover Ratio
This ratio measures the business’ effectiveness at paying its debts on time. If the ratio is low, it may indicate that the business has cash flow issues which require further examination as part of due diligence.
Stock Inventory Turnover Ratio
This ratio measures the business’ effectiveness at turning over its stock. A low ratio indicates either that the business’ stock is naturally slow-moving, or that the business has a problem with its stock levels or a problem selling the stock.
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