📈 6 Factors For Evaluating Biz Quality

INTRO

It’s Michael.

In today’s issue:

• THE WEEKLY: 📈 Evaluate Business Quality

• BEST RESOURCES: ROIC, FCF, ORG Template

Let me know what you think. Drop a reply or click the poll at the end of this email.

THE WEEKLY

I knew nothing about private equity until I worked at Realize, a tax advisor for billionaire PE entrepreneurs.  

It was the best company I could’ve worked for as a fresh college grad. It was a boutique, and my bosses trusted me, so I got to touch pretty much everything from sales to biz ops to delivery.

And I got to work closely with billionaire PE entrepreneurs. Before that, I had no clue what private equity or venture capital even were.

Growing up, I saw my mom pay for food with food stamps, so you can imagine the shock when I saw:

• Frequent 8-figure distributions

• Anonymous 7-figure charitable contributions

Realize played a big part in solidifying my decision to eventually buy a business. It gave me the foundation I needed to move forward.

I knew it wouldn’t be easy. I knew I couldn’t afford to lose money. My family was counting on me.

So I took everything I learned at Realize and added some self-teaching to make sure I was fully prepared before taking the leap.

I’m not the world’s #1 expert on this, but I believe good advice can come from people who’ve just solved your problems recently, not from those who are 100 steps ahead.

That’s why I’m writing this 4-part series: The CPA’s Role in Business Acquisitions.

This is part 1: Evaluate Business Quality

Rule of thumb:

• First, start with a quantitative analysis

• Then do a qualitative analysis

That way the insights you gain from the second will put the first into better light.

Quantitative Factors

The three to focus on are:

• Return on invested capital (ROIC)

• Free cash flow (FCF)

• Organic revenue growth (ORG)

Return on Invested Capital (ROIC) 

If a business isn't earning strong returns on invested capital, it’s a sign that margins are shrinking or the company is throwing money at bad investments. It measures operating profitability and capital intensity. 

• Formula = NOPAT / IC

  • NOPAT = Net operating profit after tax

  • IC = Invested capital

Free Cash Flow (FCF) 

Without strong free cash flow, a company might look profitable on paper but struggle to pay its bills.

• Formula = NOPAT - Maintenance CapEx

(Other Useful Metrics You Can Calculate w/ FCF)

• FCF Margin. It measures how well a company turns revenue into cash.

  • Formula = FCF / Revenue 

• Cash Conversion Ratio. It measures how well a company turns net income into cash. 

  • Formula = FCF / Adjusted Net Income

Organic Revenue Growth (ORG)

It tells you if the business is actually winning in the market.

• Formula = (Current Period Revenue - Previous Period Revenue) / Previous Period Revenue

Quantitative Red Flags

If ROIC is trending down, it could mean the business is bleeding cash on bad investments, or its margins are shrinking fast. Both are big red flags.

If FCF is tanking, that’s a red flag b/c it will be hard to pay off debt and reinvest in growth. Either:

• Revenue is dropping

• Expenses are creeping up

• Or the business is dumping cash into things that don’t generate a return

If organic revenue is stalling or shrinking, that’s a problem b/c the biz will have to rely on M&A or raising prices. Slowing revenue growth can mean:

• Customers don’t like the product/service

• Competition is heating up

Qualitative Factors

This is harder to measure because it is subjective.

But the main question you gotta ask is: what competitive edge does this company have?

There are three main categories:

• The People

• The Strategic Rationale

• The Value Creation Potential

The People

The Customers 

Question: Are they satisfied with what the company sells? Is there high customer concentration?

Why this question is important:

• Satisfied customers = repeat business, revenue stability, higher CTLV

• Poor reviews or low NPS = churn risk & low retention

• High customer concentration = higher risk that the biz fails after you buy

The Employees 

Question: How do employees feel about the company?

Why this question is important:

• High employee morale = high productivity

• High turnover = operational disruptions, increased hiring costs

The Suppliers and Vendors

Question: How much leverage do suppliers and vendors have over the company?

Why this question is important:

• Heavy reliance on a few suppliers & vendors:

  • Increase operational risk

  • Lead to higher prices

  • Operational disruptions

The Other Potential Acquirers

Question: What do other potential acquirers think about the business or industry?

Why this question is important:

• Lots of interest from other buyers? It could mean the business:

  • Is in a hot, high-demand space; or

  • Is overvalued or overhyped

• Nobody wants to buy? It could mean the business:

  • Is undervalued; or

  • The market is saturated or unattractive

The Strategic Rationale

Market Position and Competitive Advantage

Question: What is the company’s position within its industry or market? Does it have a competitive advantage (e.g., cost leadership, brand, patents, exclusive relationships)?

Why it matters:

• A strong position = durable cash flow

• A weak market position = indicator that biz can’t sustain debt payments

The Exit Potential

Question: Who would want to buy this business once I improve it?

Why this question matters:

• The exit is where you make most of your returns

• A clear, realistic exit strategy and strong interest from potential acquirers are essential for determining if the business is a worthwhile investment

• The business needs to be something others want to buy or invest in down the line

The Value Creation Potential

Scalability and Growth

Question: Is the business model scalable? Can it grow efficiently, either in the existing market or by entering new markets?

Why it matters:

• Scalable businesses have more potential to grow and achieve higher returns with less additional investment

• Non-scalable businesses have a profit limit, unless you reinvest tons of cash

Operational Efficiency and Processes

Question: How streamlined and efficient are the company’s operations? Are there clear processes in place for growth and scalability?

Why it matters:

• Efficient operations and solid processes = reduced risk of bottlenecks & improved margins

• Poor operational infrastructure = inefficiencies, mistakes, poor return on time b/c you’re constantly putting out fires

Strategic Partnerships

Question: Are there built-in relationships that can unlock value creation?

Why it matters:

• A business with strong partnerships (ie distribution, technology) has built-in channels for growth and scaling

• These partnerships are a competitive edge

Next Edition

Valuation, Finance Options, and Intro to LBO Modeling. Stay tuned.

BEST RESOURCES

• ROIC, FCF, and Organic Revenue Growth Template

THAT'S A WRAP

How I Can Help 💰️ 

I’m the owner of Divergent CPA, an advisory firm that helps business operators and business buyers with:

• Strategic tax & accounting

• Dealmaking

If you’re interested in a strategy call & demo, book a free consult with me 👇 Note: We’re keeping things small intentionally, like a boutique. So, don’t wait.