Buying a Business? 5 Important KPIs to Review Before You Buy

Business owners looking to grow their companies generally have two options: expand organically or acquire another business. Buying an existing business may involve more upfront costs, but buying the right company can allow you to expand into new markets, acquire valuable patents and achieve other goals, such as:

• Gaining valuable intangible assets. In many businesses, value isn’t based on tangible assets, such as inventory and equipment, but on intangibles—skilled and knowledgeable employees, positive culture, efficient processes, patents, and copyrights.
• Gaining a wider customer base. When you buy an existing business, you get access to a new set of customers and a larger market share.
• Diversified products or services. Acquiring a business can give you access to new products and services you can sell to your existing customers.
• Economies of scale. When you acquire another business, you can benefit from economies of scale by sharing a marketing budget, growing your purchasing power, or reducing logistics costs.
• Reduced competition. Buying a competing business reduces the number of companies you’re competing against in the market.

Before buying a business, consider seeking the help of a professional

Determining the value of a business is never easy. According to an article by PNC Bank, business owners have a tendency to overestimate the worth of their businesses because their personal connection makes it tough to look at the market objectively. If you take another business owner’s word that their business is worth the asking price, you could find yourself overpaying, or worse, feeling buyer’s remorse.

That’s why many entrepreneurs and investors seek out professional help from someone with formal training and experience in evaluating the tax, legal, and financial status of a business. Individuals who are qualified to determine the value of a business usually hold at least one of the following professional business appraisal designations:

• Certified Business Appraiser (CBA), Master Certified Business Appraiser (MCBA), awarded by the National Association of Certified Valuators and Analysts
• Certified Valuation Analyst (CVA), also from the National Association of Certified Valuators and Analysts
• Accredited Senior Appraiser (ASA), conferred by the American Society of Appraisers
• Accredited in Business Valuation (ABV), granted by the American Institute of Certified Public Accountants

If you’re not quite ready to call in a professional, but still want to get an idea of whether acquiring a target company is a good move, focus on these key performance indicators (KPIs).

5 KPIs to consider when evaluating a business acquisition

1. Employee turnover

If gaining access to experienced and highly skilled employees is a primary reason for the acquisition, you’ll want to know whether those employees are likely to stick around. Calculating the employee turnover rate can help you predict the likelihood that they stay.

You can calculate employee turnover by taking the number of employees that leave during the month and dividing it by the average number of employees, then multiplying that by 100.

An acceptable turnover rate will depend on your industry. According to the U.S. Bureau of Labor Statistics, in retail, the average turnover is 69.7%; in the finance and insurance industry, it's a much lower 25.1%.

An employee turnover rate that trends higher than industry averages can indicate that the business isn’t well run and there’s an issue with company culture.

2. Debt-to-equity ratio

The debt to equity ratio measures how much debt the company uses to run the business for every dollar of equity the owners have invested. You can calculate the debt-to-equity ratio by dividing the company’s total liabilities by the equity—both of which can be found on the balance sheet.

Again, a “good” ratio depends on your industry. Tech companies and other businesses that do a lot of research and development tend to have a debt-to-equity ratio of 2 or below, according to Joe Knight, author of HBR TOOLS: Return on Investment. In financial-based businesses, a debt-to-equity ratio of 10 or 20 is common.

3. Customer acquisition cost

Customer acquisition cost is the amount of money a company spends on sales and marketing in order to acquire a customer. To calculate it, simply divide the total marketing and advertising spend over a period by the number of new customers gained during that period.

Once again, average customer acquisition cost varies by industry. Here are the average customer acquisition costs for a variety of industries:

• Travel: $7
• Retail: $10
• Consumer goods: $22
• Manufacturing: $83
• Transportation: $98
• Marketing agency: $141
• Financial: $175
• Technology (hardware): $182
• Real estate: $213
• Technology (software): $395

A company with abnormally high customer acquisition costs could be throwing away cash with marketing campaigns that aren’t generating a return on investment.

More articles from AllBusiness.com:

• Using Key Performance Indicators to Improve Financial Performance
• Stop Losing Employees: 4 Tricks to Beat Turnover
• Buying a Business? 5 Essential KPIs You Need to Review Before You Buy
• How to Lower Your Employee Turnover Rate
• Use Ratio Analysis to Evaluate the Financial Health of Your Small Business

4. Profit margin

Profit margin indicates how much the product’s or service’s revenue exceeds the cost of producing those goods or services and running the business. There are actually three ratios to consider when evaluating the profitability of a company:

• Gross profit margin ratio. This shows the percentage of sales revenue a company keeps after covering all direct costs of producing its products or services. You calculate the gross profit margin revenue by dividing gross profit by revenue and multiplying the result by 100.
• Operating profit margin ratio. This shows the percentage of profit the company produces from operations, before subtracting taxes and interest. You calculate operating profit margin by dividing operating profit by revenue and multiplying the result by 100.
• Net profit margin ratio. This shows the percentage of profit the company produces from its total revenue. You calculate net profit margin by dividing net income by revenue and multiplying the result by 100.

As with other KPIs, an acceptable profit margin is dependent on your industry. According to CFO Hub, the average gross profit margin across all industries is over 30%. However, industries that do not sell physical products typically have higher profit margins than product-based companies because they have a lower cost of goods sold.

5. Customer retention rate

Most businesses rely on returning customers, as regularly purchased goods and services are more profitable than one-time sales.

That’s why it can be helpful to calculate the target company’s customer retention rate (CRR). To calculate, take the number of customers at the end of the period, subtract the number of new customers acquired during the period, then divide the result by the number of customers the company started with.

A low customer retention rate is a problem, suggesting that customers aren’t happy and there may be an issue with the company’s products or services. No matter how many new customers the company gains with marketing and business development efforts, if the churn continues, it’ll keep losing money.

Of course, even a lagging KPI could present an opportunity. Discovering a company with high employee turnover and low customer retention doesn’t automatically mean acquiring the company would be a bad move. However, it does signal that you don’t want to pay top dollar to the seller. You also want to be ready with a strategy for turning those KPIs around quickly post-acquisition.

Bonus KPI: Operating cash flow (your own)

Evaluating the health of your acquisition target is important, but it’s even more important to ensure you’re financially sound before taking out a business acquisition loan. There are many metrics to help you measure financial stability, but pay close attention to operating cash flow.

Your operating cash flow ratio is your company’s cash flow from operations (which can be found on your cash flow statement) divided by current liabilities (found on the balance sheet).

This metric reflects the amount of cash your business produces solely from core business operations, as opposed to cash from owner investments into the company or borrowing. Without a positive cash flow from operations, your business won’t remain solvent for long, and definitely isn’t in a position to acquire another company.

What rights do you have as a buyer?

Acquiring a business is a complex transaction and a lot can go wrong. The seller may claim the business is worth more than it appears to be worth on paper due to “cash sales” that never materialize post acquisition. You may discover the seller didn’t actually own all of the assets they claimed to, or that they had undisclosed legal, financial, or environmental problems they wanted to unload.

Unfortunately, short of suing the seller for breach of contract, there’s not much you can do once the deal is done. For that reason, it’s important to do your due diligence before buying a business.

Having a professional business valuation performed will add to the cost of acquiring a business. But acquiring a company involves taking on a tremendous amount of responsibility and liabilities—don’t leave that up to chance.

RELATED: A Guide to Acquiring a Distressed Tech Company