Investors analyze businesses differently than just about everyone else. While consumers evaluate a company purely on its products or customer service response time and employees look at the company as a paycheck provider, investors are looking at companies in the context of short- and long-term investments.
A sound investment is one that pays off, but different investors measure that payoff by different means. Some investors are looking for a quick return while others are content to wait and reap the benefits later. What all investors have in common, however, is that they need to evaluate the investment opportunity on its merits, quantitatively, without anecdotal or superfluous details.
As a result, many investors look at a company’s financial analysis to find the black and white details they need. Here’s a list of some of the most important things that can be learned from a financial analysis.
1. The Organization’s Liquidity
Typically measured via a liquidity ratio, an organization is considered liquid if its assets are easy to sell. Liquidity could be attractive to investors because it will be (or should be) easier for an investor to get his or her money from the investment.
The most common liquidity measurement ratios are:
- Current Ratio: Perhaps the most commonly used figure when determining a company’s liquidity, the current ratio takes the company’s current assets and divides it by the company’s current liabilities. The resulting ratio can be misleading, however, because it assumes that the company will liquidate all of its assets to pay its current liabilities. A more important measure is the time it takes to convert current assets into cash that can in turn pay off liabilities. Many different things can affect this timeline, including billing cycles, working capital, available cash and accounts receivable.
- Quick Ratio: The quick ratio is sometimes referred to as the “acid-test” ratio, since it’s a simplified way to quickly assess the company’s liquidity. The quick ratio is calculated by adding all cash, short-term investments and accounts receivable line items into a single sum, which is divided by the organization’s current liabilities. The quick ratio is considered more conservative, as it doesn’t account for inventory or other assets that may be difficult to turn into cash.
- Cash Ratio: While this ratio is not considered the most useful by many analysts, it’s still worth noting as a method. The cash ratio measures a company’s current liquidity based on its ability to cover all of its current liabilities. Cash ratio is determined by adding up the company’s cash, cash investments and invested funds and dividing by its current liabilities. This ratio is the most conservative, and provides an interesting perspective on liquidity, but not much else.
2. The Organization’s Activity Ratios
An important aspect of any company, especially one seeking investors, is its activity. In the financial world, activity indicates how a company is managing its assets. This normally involves measuring inventory turnover and daily sales outstanding (DSO), which refers to a business’ average collection period in days.
For the most part, a company that can turn over its inventory and collect outstanding debts quickly is a much more viable investment choice. High inventory turnover indicates that a company is not over-ordering or allowing valuable merchandise to sit in a warehouse. A high DSO value shows that an organization is waiting for payment, which would increase its current liabilities.
3. Performance Trends
One of the best uses of a financial analysis is the bird’s-eye view it takes of the organization’s accomplishments, finances and trends. Performance trends outline the company’s highs and lows over a given time period. These trends also help investors get the full picture on where the company is heading and/or illuminate an up-and-coming trend that the company may be capitalizing on.
Performance trends typically take into account the company’s overall performance, but can also provide more in-depth insights.
4. Competitor Data
Knowing what’s happening among a company’s competitors is crucial information investors must know when making an investment decision. Not only do the competitors’ positions in the marketplace help to predict challenges or opportunities in the short- and long-term, comparing a company’s value against its competitors is one of the easiest ways to gauge an investment’s true worth. This information also helps investors negotiate deals from a position of knowledge.
5. Industry Standards
Similar to competitor data, industry standards are an important benchmark to measure an investment opportunity against. For the most part, industry standards are unchanging, or change very slowly over time, so a company’s performance in light of these standards can very easily illustrate success or failure.
6. Balance and Income Statements
While these may seem like a given when discussing financials, and not all that complicated, the amount of information that can be gleaned from a company’s balance sheet shouldn’t be underestimated. The same is true of income statements. While much of this analysis should be included in the bulk of the financial analysis, perusing these documents with a fresh set of eyes is not a bad idea. Most of the base numbers used in ratios throughout the report can be found in these documents, giving you the chance to further crunch the numbers if you choose.
By understanding what an investor is looking for when perusing a financial analysis, you as a small business owner can better understand how your current finances, liabilities and trends will affect their belief in your company as an investment.
Using financial analyses to evaluate the competition is a great idea, especially if you’re thinking of entering the market with a new product or service. To help you see if your business idea has what it takes, here’s how to conduct a thorough competitive analysis.