Founders will always be considering what their business might be worth – and for good reason!
They may want to:
- evaluate their own personal progress or success
- ensure shareholders are satisfied, or
- pitch to new investors.
In this article, we focus on No.2 and No.3.
We examine the most important finance and accounting related items that an investor or shareholder will want to understand when evaluating a business.
So let’s start with financial performance!
1. Financial Performance
First and foremost, investors and shareholders will want to see a positive return on their investment. They will want to know that the business is performing well from a financial perspective.
So how do you measure financial performance? From both a historical and a forward-looking point of view.
Investors can evaluate financial performance by looking at historical financial data. There are a number of ways in which financial statements can be considered:
- Horizontal Analysis – Analyzing growth or decline of accounts across different time periods or accounting periods. Increasing gross profit margins are positive signs for investors and shareholders.
- Vertical Analysis – Analyzing financial statements where each account is evaluated from the perspective of margins. Taking revenue as an example, measuring profit margins will show what proportion or percentage of the value of sales remains after all applicable expenses have been paid off. Shareholders and investors like this ratio as it identifies how efficiently a business can transform their sales into net income.
Shareholders and investors are also interested in the future potential of a business. There are two main ways to measure future performance:
- Forecasts – a measure of future financial performance based on a company’s historical financial information. Forecasts are used to generate a forward-looking analysis of what the future financial position of a business is likely to be based on recently available information.
- Budgets – shorter term objectives that the company is seeking to achieve. It is a representation of how management is directing the business in the very near future. Budgets are more concerned with operational and day to day activities.
Both forecasts and budgets are important if you want to illustrate to investors and shareholders that the business can generate real growth. See our recent blog post for an in-depth analysis on why budgets and forecasts are necessary for growth.
2. Strong Cash Flow
If a business does not have sufficient cash reserves to sustain operations, it will encounter serious financial problems.
For this reason, investors and shareholders seek to invest (or continue to invest) in businesses that are consistently able to generate enough cash to cover daily operations.
There are many ways investors measure cash flow. A common measurement method is the “Cash Conversion Cycle” or CCC.
The Cash Conversion Cycle is a metric that estimates how a company collects and uses cash, beginning from the initial cost of inventory to receivables collections to the payment of liabilities. The formula for calculating CCC is:
CCC = Days of inventory outstanding (DIO) + Days of sales outstanding (DSO) – Days payables outstanding (DPO)
As a general rule, the shorter the CCC, the stronger the cash flow of the business.
- Days of inventory outstanding (DIO) = an estimate of how long inventories remain in stock before they are sold. The shorter the DIO, the faster the business sells its inventories. Check out our recent article on inventory bookkeeping for retail businesses in the Philippines.
- Days sales outstanding (DSO) = the time it takes for customers to pay. The faster a customer pays, the shorter the DSO and the better it is for cash flow.
- Days Payable Outstanding (DPO) – how long it takes for a business to settle its payables. Where payment terms are longer, businesses will be able to use the cash for something else (e.g. the purchase of additional inventories). Investors may look for longer DPOs.
3. Healthy Financial Position
Investors and shareholders are particularly interested in two current business metrics: liquidity and solvency.
This measures the ability of a business to pay off its short-term liabilities using assets that can be converted to cash with ease. A common measure of liquidity is the Current Ratio.
The Current Ratio is computed by dividing Total Current Assets by Total Current Liabilities. The higher the ratio, the better the ability of the business to pay off its current liabilities.
A current ratio higher than 1 means that there are sufficient current assets to cover current liabilities. Investors and shareholders will want to see current ratios that are higher than 1.
For a detailed explanation on the terms “assets” and “liabilities”, check out our recent article on the 7 key accounting and bookkeeping concepts that businesses must know.
This measures the ability of a business to pay off all of its liabilities using all of its existing assets. Common ratios used by investors and shareholders to measure solvency are the “debt-to-assets ratio” and the “equity-to-assets ratio”.
Let’s say for example that a business has P1M in total assets, P400,000 liabilities and P600,000 equity.
With this information, we can conclude that the debt ratio is 40% (P400,000/P1M) and the equity ratio is 60% (P600,000/P1M).
Investors will also want a higher share of the assets or a higher equity ratio. This is true unless they are investing in an industry where debts are integral to a business model. For example, in the banking industry, where banks may not own much of the cash making up their loans.
4. Full Compliance
One of the most important things for investors and shareholders is that the business in which they are (or will be) investing is fully compliant with relevant laws and regulations. Issues can often arise during a due diligence process in investment transactions.
Compliance issues, particularly at the corporate governance level, can also be a trigger for shareholders to pull out.
There are a number of important bodies in the Philippines to consider when thinking about compliance. Three important government agencies that deal with compliance and regulation are the Bureau of Internal Revenue, the Securities and Exchange Commission and the Department of Labor and Employment.
The BIR is the tax collection government branch in the Philippines. The BIR has the mandate to collect taxes and investigate companies for tax compliance through the conducting of audits. Tax audits are examinations to check the accuracy of data a company has reported in their tax submissions. An audit or investigation may also arise where no data has been reported!
The SEC is the regulatory body mandated to supervise corporations and capital market participants, monitor securities and corporate investments and protect individual/private investors.
DOLE supervises and regulates all labor and employment related matters in the Philippines. Its aim is to protect workers and their welfare, promote gainful employment opportunities and to maintain industrial peace.
Again, compliance is a key element of what an investor will look for when performing a due diligence on a company. Shareholders will also want to ensure the company is in good standing from a compliance and regulatory perspective.
5. A Robust Business Plan
An investor or shareholder will need to know the direction, plans and strategy of the business in which they have invested or are considering investing. This information will generally be contained within a business plan prepared by management.
A business plan contains a comprehensive and detailed outline of how a business intends to make a profit. Here are some of the key components of a business plan:
a. Target market
b. Financial budgets and forecasts
c. Marketing goals and plans
d. Competitor analysis
e. Risk analysis
f. Investment requirements, potential return on investment and timeline of when returns will be achieved
i. Investment structure – the mix of liabilities and equities that will be used by the business
Preparing a business plan can be tricky. It requires an understanding of the entire business as well as the finances and accounts. A finance expert with commercial expertise, such as a Chief Financial Officer, can help significantly with the preparation of a business plan.
And remember, if you don’t want to hire directly, a CFO can be outsourced! Here are some of the benefits of outsourcing a CFO in the Philippines instead of hiring an in-house CFO.
Outsourced accounting and bookkeeping services in the Philippines
Investors and shareholders will invest or remain invested in a business that performs well in the market, can show that it has a clear direction and strategy, implements robust internal policies, processes and controls and generates solid financials.
CloudCfo, the outsourced tax, bookkeeping and accounting service provider for companies in the Philippines, is a growth partner for our clients.
This means that we integrate ourselves into our clients’ businesses and implement value-added processes and controls that give companies a platform to scale. We will not only ensure your business has robust financial reporting systems in place – we continue to work with our clients to help them achieve their growth objectives.