Why You Need to Know Your Profit Margins and Ratios

By Generational Equity

04/03/2017

One of the most important exercises our award-winning evaluation team conducts during the initial evaluation phase of our client engagements is a full profit margin/ratio analysis examining both in to two key areas:

1. Financial ratios in comparison to industry norms
2. Profit margins per product/service/client line

From an M&A analysis and modeling standpoint, both are critical. Why do we do this during our initial evaluation of each client? Because buyers will be doing the same. We want to be able to clearly highlight positives regarding our client’s margins and/or create meaningful strategies for them to improve or enhance their margins/ratios in both areas.

Since many of you did not major in corporate finance while in college and few of you are CPAs,  we will first delve into the financial analysis area, industry norms, and in our next article we will explore the importance of margins by line.

First, comparing your margins to industry norms is a creative way of determining where your business stands in relation to your competitors. Although many sources exist for this information, the market-accepted organization that has compiled the most relevant industry norm data is the Risk Management Association (RMA). I have been using their data for more than 30 years and have found that is has improved greatly over time as they gather more and more relevant industry financial information.

According to their website, the RMA:

Is a not-for-profit, member-driven professional association serving the financial services industry. Its sole purpose is to advance the use of sound risk management principles in the financial services industry. RMA promotes an enterprise approach to risk management that focuses on credit risk, market risk, operational risk, securities lending, and regulatory issues. Founded in 1914, RMA was originally called the Robert Morris Associates.  Today, RMA has approximately 2,500 institutional members. These include banks of all sizes as well as nonbank financial institutions.

Given its longevity, size, and the scope of work, I have found RMA to be a very credible source of industry margin comparisons. Although they produce a number of reports in a variety of useful formats, what is most applicable for business valuation purposes is their RMA Annual Statement Studies, which provide annual information regarding industry margins for banking, valuation and consulting professionals. Again, per their website:

RMA's Annual Statement Studies® is the only source of comparative industry data that comes directly from the financial statements of small and medium-size business clients of RMA’s member institutions. For over 97 years, RMA has been the leader in providing the industry with reliable, and accurate benchmarking figures including balance sheet and income statement line items, and 18-classic industry average ratios.

If you would like to see a sample of their ratio analysis in action, you can do so here (this is for the soybean farming industry so any of you in that niche now have comparable data you can use).

If you drill into the link above, you will see compiled balance sheet and income statement data from industry players and a series of key ratios that can be used to compare a specific soybean operator to industry standards over several historical years, as well as by size of industry participant.

Liquidity Ratios are Vital

Two key areas that many buyers will look at are the Quick and Current Ratios of a target. For laymen, these are defined as:

• Quick Ratio – measures a company’s ability to meet its short-term obligations with its most liquid assets and is calculated as follows: (Current Assets – Inventories) / Current Liabilities.
• Current Ratio – (also known as the working capital ratio) a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. It is calculated thusly: Current Assets / Current Liabilities.

It is easily seen why these two ratios are quickly reviewed by buyers who want to ensure the financial viability of their target investments.

As you can see in the example given of the soybean industry, the median Quick Ratio in the last historical fiscal year (second page for 3.31.15) is .7 with an upper quartile of 1.6 and a lower quartile of .2. So, from a financial analysis standpoint, you would want your operation to be closer to 1.6 than .2.

Likewise, the median Current Ratio is 1.2 with the upper quartile at 2.5 vs a lower quartile of .4. Here again, from a buyer’s perspective, it is hopeful that your target will be closer to 2.5 than the bottom end of the spectrum.

The good news for our clients is that if we see that either of these ratios (and several dozen others) are below industry norms, we offer a Roadmap to Enhancing Value document that outlines key metrics from a financial analysis standpoint that could lead to significant improvement. If you have a plan to improve any of your key ratios and margins, buyers will usually look far more favorably on your business than if you do not. And if a buyer asks you during due diligence to provide your Quick and Current ratios and you are unable to do so, red flags will go up immediately.

One of the unique features of the Generational Equity procedures and policies is the in-depth financial analysis that we do on our clients BEFORE taking them to market. This allows us to not only provide the owner with an opinion of value, but also enables us to analyze key financial metrics in relation to industry standards and provide our client with ideas on improvement – this will be key when eventually talking with buyers.

To learn more about M&A financial analysis, I recommend that you attend a Generational Equity M&A executive conference. These no-obligation meetings are designed to allow you in a few short hours to gain significant knowledge about how important your preparation for an M&A event can be.

To learn more, call us at 972-232-1121 or email us at info@generational.com.

By Carl Doerksen, Director of Corporate Development at Generational Equity.

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