Investing isn’t complicated in theory. All we have to do is take the money we have and buy a portion or an entire business. Business needs to grow and either produce income for us that is reliable or grow enough to make a profit when we sell it. One of the crucial skills required is learning how to understand business finances.
Throughout the article, we will come back to the example of a small website as an investment to illustrate the points.
Does the business have a Strong or Weak Balance Sheet?
The first step to figuring out business finances is to look at the balance sheet. Even when investing in an online business like a single website, you should imagine it has a fully operating balance sheet. A strong or a weak balance sheet can decide the fate of your investment.
The primary goal is to figure out if the cash flow is predictable enough to pay off all the debt & obligations (off the balance sheet debt). Not only do we want to make sure that debt can be serviced, but what if the cash flow declines in the future? Are we going to be okay? If we buy a business as an example that our family will depend on, is there enough margin of safety to ensure our families don’t go hungry? It may sound dramatic, but businesses usually fail because of too much debt and insufficient cushion to handle downturns.
When buying businesses, we buy income streams—the more stable the cash flow, the higher premium we will typically pay.
Why does the business have debt?
Why is the business in debt? Was the primary goal to use it as leverage to expand into new areas, buy another company, expand the product line? Could the profits be reinvested instead? Are the owners trying to use leverage to maximize the value of the business?
Going back to the website example, it is unusual to see small website businesses carry debt. But there is another item that is just like debt, paid website traffic. If an online business depends heavily on paid traffic sources, these are obligations they have to continue paying regardless of revenue.
Benefits of low debt
There are two primary benefits of low debt:
- Low risk of going bankrupt
- Frees up money to reinvest in better things
Number one should is obvious. If something happens to the business and revenue declines, you are not sweating it at night; hoping lenders don’t come knocking.
Number two, during downturns, leveraged companies suffer X times their leverage. The higher the leverage, the more it hurts. Businesses with no debt can be opportunistic during these times and invest and grow and come out of the bad times even stronger.
How much debt can a business take on?
Debt is not all bad. Using debt to finance growth is a wise strategy. Just like eating sugar is not necessarily bad for you, excessive amounts cause problems. The same goes for debt.
Then there are different types of companies and businesses that can take on different amounts of debt. Just like a person who is pre-disposed to having problems with blood sugar should not overeat it; the same goes for certain businesses and debt.
The ability to take on debt depends on two factors: Internal & External.
Profitability, stability, asset composition determine how much debt a business can take on. In the end, it comes down to the stability of the cashflows. The more stable the cashflows, the more debt a business can take on.
For example, an online blog with stable Google rankings and constant traffic that makes money from display advertising can take on debt more freely than an e-commerce store specializing in Christmas gifts.
Seasonal cashflows have to be a consideration. Remember that lenders don’t care about the seasonality of your business, but your customers do.
External factors that will affect the ability to borrow are interest rates/difficult vs. easy credit environments and what the competition is doing.
During periods of low interest rates, the cost of borrowing is down, and it might make sense to borrow during that time, but you always have to consider the competition & the future. Can a business get ahead by borrowing today, and what will happen when rates go up in the future?
Don’t forget Contractual Obligations
Something that needs to be considered that doesn’t fall under the debt category is “off the balance sheet” obligations.
Most common obligations include: Lease Obligations & Contracts. Leases are expenses and reduce profitability that have to be paid regardless of income.
Purchase contracts require the business to make purchases regardless of inventory levels or income levels. These obligations can make or break a business if the margin of safety is meager.
Use Coverage Ratios
A quick way to understand if a business can meet fixed obligations is to calculate a coverage ratio.
Popular coverage ratios are EBITDA to Interest Expense, EBIT to Interest Expense, and Operating Cash Flow to Interest Expense.
We prefer using Cash Flow to Interest Expense because liabilities need to be paid in cash. Earnings don’t take into account everything, and if you are investing in outside business, earnings reporting can be easily manipulated.
Remember, the more cyclical the cash flows, the higher the coverage ratio is preferred.
Ratios, however, are snippets in time. To make full use of them, we have to analyze them over some time. The longer, the better. Coverage ratios will fluctuate with seasonality, so keep that in mind.
To learn more about Coverage Ratios check out Corporate Finance Institute.
It is essential to understand how liquid the balance sheet of the business you invest in is. Liquidity means how quickly a business can convert assets into cash. The most liquid asset is cash on hand, then there is any inventory and things like accounts receivable.
Cash is easy to understand unless the business has cash in different countries that might impose problems. Another consideration is how seasonal are the cash holdings. A company might report a lot of cash today but will need a lot of it tomorrow to fulfill a contractual obligation to buy inventory.
Inventory turnover is a metric that measures how quickly a business can sell inventory and turn it into revenue. The quicker, the better, but that can also impose restocking challenges and require closer monitoring of inventory levels. Longer turnover means inventory needs to be kept for longer. That will impose higher storage costs.
Long Term Liquidity and Final Thoughts
We looked at how to understand business finances for the short term. Long-term liquidity is harder to analyze. A few things to consider for the long-term is the source of financing. How permanent is it? There is debt, but also there is equity financing (Selling shares of a business in exchange for funds). Short-term funds are temporary and a more risky source of capital. Long-term equity capital doesn’t come due, doesn’t have an interest expense or margin calls. Equity capital does have its downsides, however. Primarily, dilution of business ownership.
To conclude, understanding business finances can get complex if you get into the details, but at a higher level, it is about two things: How stable are the cash flows, and what are the obligations that need to be paid?
Avoid investing in businesses where calculating cash and debt requires a Ph.D. If you can’t figure that out quickly, further analysis will not help. We love businesses with little to no debt and cash flows that are incredibly boring to chart as they look like a steady increasing straight line.
Boring! Is Good!
These are just the first few steps how to understand business finances. Then comes analyzing the products, the market, the management, and any potential developments, both internal and external, that can impact the business.
Debt and the inability to pay it are why companies go bankrupt. We must understand these first to figure out if the business is worth investing.