From The Income Statement
The income statement can give you a good overview of how well a business manages current loan interest. You can also understand how much the company pays to its shareholders, the percentage of revenue it keeps as net profit, and the profit margin from sales.
2. Net Profit
A company’s income statement can inform you about its performance and current financial position. It shows revenue, expenses, and profits for the specified period.
The gross profit is determined by subtracting production costs from the revenue. When other expenses are subtracted from the gross profit, the result is the EBIT, or earnings before interest and tax.
Once interests and tax are subtracted from the EBIT, the resulting sum is the company’s net profit.
3. Operating Expenses
A detailed look at the expenses is precious when reviewing the income statement, as it will give you a clear picture of the real profit.
Operating expenses include the necessary funds spent on supporting vital business operations. These expenses should ideally be outlined in great detail. If they aren’t, it should immediately raise a red flag. This also gives you an idea of potential areas where you can impact the bottom line as the new owner.
4. Gross Earnings
There’s a crucial difference between gross and net income, and understanding this difference will give you a great insight into a business’s health.
Gross income is the amount of money earned before deductions and taxes, while the net amount is what’s left after all deductions.
Gross profit is a good orientation point for assessing the company’s efficiency. How a business uses its resources to produce goods or services is vital in determining how it will perform financially.
By looking into the gross values, you can understand how much it will cost to generate revenue.
5. Gross Profit Margin
Getting your arms around the financial performance of a business can be overwhelming to first time acquisition entrepreneurs; however, these metrics paired with gross profit margin will allow you to quickly assess the overall performance of the business and future potential.
Gross margin is calculated by dividing the gross profit or earnings by revenue then multiply by 100 to get the percentage.
This tells you if your sales are enough to support expenses. It also gives you an idea of how lean the business is and how significant the margin of safety is for that business.
A business with a small profit margin suggests there is little room for error before becoming unprofitable; whereas, a larger profit margin provides a level of comfort that as the new owner, you can make a few mistakes without sacrificing your investment.
6. Contribution Margin
One of the most important ratios to consider when you’re evaluating the attractiveness of a business is the contribution margin. This calculation is absolutely critical to understanding your growth strategies as well as your break even analysis. Aside from helping understand how significant the margin of safety is, it can help identify whether to pursue new products, discontinue existing products, change pricing structures, or adopt new pay strategies.
Contribution margin is calculated by subtracting your variable costs from your revenue then multiple by 100 to get the percentage.
This explains how much of your fixed costs are covered by your revenue. You can expect to see lower margins with service businesses that have higher variable costs while manufacturing businesses that are capital intensive will have higher margins due to having increased fixed costs.
Be Thorough With Your Due Diligence
You should proceed with the purchase only once you’re confident that the business in question is healthy enough. Understanding the numbers and how they apply to a business will provide you with a clearer view of the company.
Make sure to do your due diligence right and you’ll know if the business you’re interested in would make a good acquisition.
If you plan on buying a business in the next 12 months, please consider applying to the Acquisition Lab. We have a vetted group of buyers and a do-it-with-you buy-side advisory service. Please feel free to apply and get world-class education, support from our team of advisors, and a suite of tools and a vetted community to help you succeed in that first acquisition or in implementing a grow-through-acquisition process.