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Analyzing Business Financials (part 2)

If you’re considering buying a business and want to determine its financial health, here are a few more measurements that might help you.

Fixed Asset Turnover.  Purchasing of plant and equipment are typically a business’ largest outlays.  How well are they performing.  Divide revenues by the average property plant and equipment (beginning versus ending PP&E divided by 2).  The higher this ratio, the better the business is doing at turning its assets into profit.  Of course, not all companies rely on capital expenditures to do business, so keep this in mind.

Sales per Employee.  Divide total revenues by the total number of employees to determine how much money the enterprise is making on each employee.  A bigger number is better.  But, just like Fixed Asset Turnover, keep in mind that all businesses are different; this ratio will look different on a firm that is less labor-intensive. 

Gross Profit Margin.  Gross Profit is total revenues less the cost of goods sold.  Take Gross Profit divided by Sales to determine the gross profit of every dollar of sales.

This measures the company as a whole, however.  You can focus this ratio even further to determine the gross profit margin for each type of product sold.  For example, if you’re not sure whether Product A or Product B is the better performer, calculate Gross Profit Margin for each of them.  Businesses use this type of analysis to determine which product lines to keep.

Operating Profit Margin.  To find out the profit on every dollar of sales after all inventory costs and sales expenses are considered, take operating profit (gross profit less operating and sales expenses) divided by total sales.  This will give you an even more focused view of what the company is able to retain in profit after all its necessary operating expenses are considered.

Net Profit Margin.  The strictest measure of a company’s profitability, this takes Net Profit divided by Sales.  This gives you the most narrow measure of how well the company is controlling operating expenses in order to turn a profit. 

Operating Cycle.  This is the most complicated to calculate, but worth it.  If a business isn’t turning sales into cash, it’s not worth your investment.  The Operating Cycle is Days Inventories Outstanding plus Days Sales Outstanding less Days Payables Outstanding, where

Days Inventories Outstanding = Average Inventories (beginning inventory plus ending inventory divided by 2), divided by the cost of sales per day (cost of sales / 365).

Days Sales Outstanding = Average accounts receivable (beginning A/R plus ending A/R divided by 2), divided by net sales per day (net sales divided by 365)

Days Payable Outstanding = Average accounts payable (beginning A/P plus ending A/P divided by 2), divided by cost of sales per day (calculated in Days Inventories Outstanding, above).

Once you add these together, you’ll see how many days, on average, it takes a business to turn sales into cash.  The shorter the cycle, the more liquid the business.

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