Business Valuation Ratio
These are some ratios you should be familiar with in researching a business or franchise, or in the hope of making one more profitable.
Liquidity Ratio
This is the total assets divided by total liabilities. It offers a rough idea of the current ability of a business to meet it's obligations. The higher the ratio, the larger the comfort zone!
Quick Ratio
All cash plus accounts receivable divided by total liabilities. This will offer a rough idea of what cash would be available if a business were to just shut it's doors and liquidate. A ratio of 5 would give you 50 cents on the dollar.
Inventory Ratio
Total cost of inventory sold divided by the average ticket/sale price. This will give you a ratio of how many times an item is turned or sold. Going to one extreme creates excess inventory while on the other end you may not have enough inventory and lose sales. Each business is different as well as high end vs. low end. High end retailers may sell a top of the line garment (lower profit) once in a month while a low end (higher profit) may sell several times over in a week. One brings in customers the other rings up sales. Restaurants need the $100 bottle of wine to help sell those 3-4x time marked up affordable ones.
Gross Margin return on inventory (GMROI)
This is simple, but important. The gross profit on inventory is divided by the average profit of the inventory. Again, low end items may be marked up 800% while a high end is only 40%. Take the average profit across the board. If the average is 2, that means for every dollar you invested, you earned $2 more in profit.
Debt to Ratio
Calculate what the business owes and divide it by stockholder equity. A low number may mean the company is able to borrow against itself. A high number may merely mean it is leveraged and poised to capture market share.
Debt to Service
This is the one the banker always uses to dazzle us with! This determines whether the borrower has the ability to pay back the loan. Take the net income, plus interest expenses and depreciation expenses, added together and then divided by the long term debt. (Debt may be actual or what you are trying to borrow.) This one is payback for profits that somehow do not reach the books. If it doesn't show, you can't borrow against it. And you can't sell it!
Profit vs Cost
You buy an item for $5 and sell it for $25. You make $20 profit. Well, you buy another item for $100 and sell it for $200. Obviously you made more money, quicker and easier the second time around.
But which was more profitable? The first item had a profit of 20 divided by a cost of 5 for a markup/profit of 4.00 (400%).
The second item had a profit of 100 (!) divided by a cost of 100 for a markup/profit of 1.00 (100% or keystone) Hmmm. We made more money but less profit. Many do not see this or understand the concept no matter how many times it is pointed out.
I would much rather have a plain old pizza pasta house doing doing $10,000 per week than a 5 star gourmet restaurant doing $20,000 per week. One runs food cost of 18-20% and the other is 40-50%! I have been to both owners homes. Trust me the pizza guy is doing ok!
Now, how do you use these?
If you are selling, you should be aware of them. Fix what is fixable or have an explanation should someone ask.
If you are buying, do your research before you ask the seller a question. If you see a figure and it is out of line, think before you ask about it. Perhaps the seller does not know or understand. As soon as you point it out, the seller may fix it himself. If so, a marginal company may be on it's way to being profitable. The price will rise or it will come off the market. You on the other hand lost out on an incredible opportunity. As a broker, I used to 'fix' many seller's businesses. Now I keep my big mouth shut and sell them. No one pays me to fix them. Most times, I did not even get a thank you!
Knowledge of what to do with a company may have more value than the books or assets of the company... that is opportunity. Acting on it, is what few are capable of.
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