How To Assess A Potential Investment In A Business For First Timers

Planning to invest in a business for the first time?

It can be a daunting prospect. On the one hand, it could be a lucrative opportunity to exponentially grow your investment and generate a good return. On the other hand, you face the risk that you could lose your money completely, if things don’t go as planned.

Ah, the investor’s dilemma…the eternal balancing act between potential risk and potential reward…

Don’t worry, help is at hand. While there is obviously no way to totally mitigate risk, here are some tips to help a new investor, evaluate the business opportunity in a more informed way. Using these methodologies, you might be able to discover some information that will at least better equip you to make a more informed decision before putting your hard-earned capital, into a business venture.

Firstly, we should understand that there are a range of factors that should be evaluated when assessing a business. Some are financial in nature, while some are non-financial in nature.

So what should we look for?

1. Look at the past performance of the company. This approach takes a historical perspective. Here, the financial statements are the “magic document”. All the info on past performance can be extracted from the numbers and from calculating some of the key ratios.

Generally, there are 4 key classes of ratios ie. liquidity, solvency, profitability and efficiency. Some of these key ratios are the current ratio, and debt-to-equity ratio, ROE (Return on Equity), ROI (Return on Investment), ROA (Return on Assets) and ROIC (Return on Invested Capital). It must be noted however that the level of insight a potential investor can glean from these ratios, depends very much on the nature of the business, the type of industry and other subjective factors.

2. Look at is how much money the company makes, and how much of that is turned into profit. Look at how the company performed last year, and compare with its performance this year. Also look back 3-5 years to spot trends. Is the Management of the company able to successfully convert revenue generated from business activities (such as sales of products/services) into profit?

Here, a couple of other ratios would be helpful in your assessment, such as gross margin (ratio of profit to sales), gross profit (sales minus COGS or cost of goods sold), net income margin (ratio of net income to sales) and operating margin (ratio of operating profits to sales). You could also look at the operating profit, which is derived from gross profit minus operating expenses, plus net income which equates to operating profit minus interest and tax.

3. Do some digging to find out more about the operations of the business. Are key operational components such as accounts receivable and inventory turnover being efficiently managed so as to optimise operations? This is a good way to assess how efficiently the current management is running the company. It allows you to spot potential flaws and weaknesses in the operations systems which could be negatively impacting the profitability of the business.

4. Due diligent with some key ratios which will help with your assessment here are efficiency ratios such as inventory turnover (ratio of cost of goods sold, to the inventory held by the business). If this ratio yields a high value, it means that inventory is efficiently converted into sales, and this is good news.

Another ratio to look at is the ratio of uncollected payments/sales on credit, to amounts paid by/received from the customer. Again, when the accounts receivable turnover is high, it means that the company is collecting its outstanding payments in a timely manner which is good for business.

To find out more about these and many other ratios and how to apply them to your assessment, just google any one of these ratios and a variety of free resources will guide you further.

What about non-financial metrics?

Taking a forward-looking perspective, you’ll want to get a gauge on how the business is likely to perform in future. To an extent, this is really the most important question, as the answer will determine whether you will lose money or make money on this venture!

But sadly, no crystal ball for you to gaze into here. No one can be 100% sure how a business will perform in the future, it’s pretty much guesswork and luck. But, there are some things to look out for which can help you with your evaluation.

Here’s where some industry/domain expertise would come in very useful:

i. If you are familiar with the business you’re investing in, your experience and domain knowledge will give you a keener insight into the details than someone who is going ahead only on the numbers without understanding the back story. Like everything else, domain expertise can be learnt even if you don’t already have it. Start reading up, researching, talking to people in the business. Use every available free (and if you have the means, paid) resource at your disposal to deepen your knowledge and understanding.

ii. In today’s fast-paced world, today’s incredible business success story could be tomorrow’s sad failure. Carry out a SWOT analysis on the industry to check out threats, risks and also opportunities, impacting the business. For links to some free SWOT analysis tools.

iii. Keep abreast of industry developments. Stay up to date with domestic and international business news. It’s also a good idea to do some comparison/benchmarking. Look at the performance of the company or business against that of its competitors in the industry. This should not be a challenge for companies in established/mature industries.

However, if you are thinking of investing in a startup, or in a company operating in a new or super high-tech space, you might not have easy access to comparison models. For such businesses at the cutting-edge of technology, you may need to look overseas to global markets for guidance.

Happy investing and wishing you all the very best in your investment decisions in 2015!