!Super-Important! Before reading this article/post ensure that you roughly know where the industry of the company that you are trying to acquire is in its cycle. This is by far the easiest and best tip I can give as everything from thereon will cascade accordingly.

When looking to acquire small companies the need is to focus on its growth potential.

But how can we know its growth potential?

Here we will look at some signs and indicators through the Financial Statements (FS).

Have in mind that you should not look only at the FS in isolation when deciding whether to buy a target company but through doing a proper due diligence.

The reason for the article is that, after the initial talk and pleasantries, your first tangible point of contact with what you are potentially buying are the FS.

!Important notice 1! The Financial statements are historical data! Meaning it looks at the past! And we are buying the future!

*However* The historical data are the outcome, the results if you will, of the company’s ability to turn inputs through its processes into outputs.

For the purposes of this article, we are looking at the (US) Swimming Pool Cleaning Services industry.

1.) Through its financial statements the company has to show that is at a minimum stable and profitable.

Here’s what you need to look at:

The profit or loss statement.

You need to obtain at least 2 FSs as each FS states the audited year and the comparative year, that is the previous year. So, in this case you’ll have 2021 FS which will also show the 2020 amounts, and you’ll need also the 2019 FS which will show the 2018 FS comparatives.

You can look at a trend of the last four years, however you should go for the last 3.

Look at the trends in revenue, is the revenue increasing each year? The net profit? (That is revenues minus expenses)

Depending on what you see, understandably questions will arise.

Through IBIS World you can see that the average profit margin is at 11,20% for this industry, if the profit margin of the target company is substantially lower, say 7% it means there are inefficiencies and it is something of concern. Likewise, if it is substantially higher, say 15% again the reasons must be assessed.

(Also remember that sometimes the lower or higher profit margin may not be of concern when talking generalities as the “average” of the industry is essentially the middle point of the highest and lowest.)

Say for the year 2019 to 2020 the revenues are increasing at a rate of 2%, and for the year 2020 to 2021 there is a spike of 8%; you will ask the seller why was there this increase.

It could be a variety of reasons, say everybody on lockdown who had a swimming pool wanted it clean to enjoy it as they stayed home, so more demand for these services. It could be a new contract with a gated community, e.t.c - The reason they give you – remember – tells you something about the ability of the company to grow, or if it is a one-off, in which case you need to gauge its potential.

2.) Look at the Receivables in the statement of financial position, are these abnormally high, inconsistent with the industry’s level of receivables and growing from year to year? That could be a “faux” growth in the assets part of the company, in the sense that the company is providing services to customers who don’t pay, and potentially not planning to pay, but the company shows that it is owed money.

Inquire about this. Are there reasons for this? Are the clients dissatisfied with the services provided and don’t pay?

3.) Look at the statement of changes in Equity. What you want to see here is that the company has ideally only the title “Retained earnings” and not “(Accumulated losses) / Retained earnings”, which essentially indicates loses at some point which later on profits covered.

Again, as you might have imagined you’ll want the retained earnings number growing year after year.

Another sign of growth is that when you see “Dividends paid” under every single year, this means that cash was taken out of the profits of the company.

The cash could be used to reinvest in the company in order for it to grow, but as a growth sign this is very good.

4.) A positive cash flow simply means more cash flows into the till than out of it, which is essential for a company to sustain long-term growth, *HOWEVER* positive cash flow doesn’t prove that the business is profitable, as the cash could be out of a loan or sale of a fixed asset, such as the van that is carrying the cleaning equipment and the personnel.

The number you want to see rising year after year here is at the bottom line of “Operating cash flow” the “Net cash from operating activities” – this is an indicator that cash is generated from activities related to operations.

Final thoughts:

Those are just basics to help you better understand the financial health and growth prospects from within the company and how well a company responds to the external factors affecting the industry, and gauging if it has the ability to take advantage or respond accordingly to market conditions.

It is imperative to have an understanding as well of the external factors and particularly how experienced the management is in the particular industry and the ways they deal with the conditions under each cycle.

There are way many, many, things that determine the health and prospects of the company many of which are interconnected but I didn’t go through in this article, but will probably go through in another article.

Hope this helps!