One of the most important procedures done in preparing a business valuation is the ratio analysis of the subject company’s financial statements. The calculation and review of financial ratios will assist the valuation analyst in determining the strengths and weaknesses of the company.
The major ratio groups to consider when valuing a company are:
- Liquidity Ratios: Current and Quick Ratios
- Activity Ratios: Inventory and Accounts Receivable, Turnover and Contribution Margin
- Risk Analysis Ratios : Degree of Operating Leverage and Margin of Safety.
- Solvency Ratios: Debt to Equity And Working Capital
Important trends in a company’s financial performance can be discovered by examining the above ratios over a period of time( 3-5 Years). Such an analysis will aid in determining how the company compares to similar companies in the same industry.
Generally, the higher the level of business risk and unfavorable financial ratios, the lower the fair market value of the company. While companies with favorable ratios and better financial performance will command higher valuations.
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