How to Know if a Company Is a Worthwhile Investment

Small businesses can use excess capital to buy another company as an investment. Whether you're investing for cash flow or to expand, it's always worth your while to assess the target's financial strength before making a decision. Return on equity, or ROE, is commonly used to measure company performance because it incorporates profitability, asset efficiency and financial leverage. In fact, ROE is a product of those attributes.

ROE Breakdown

Calculate return on equity by dividing a company's net income by shareholder equity, which can be arrived at by multiplying profitability by asset turnover multiplied by financial leverage. A high ROE means investors are making more money per dollar invested. A company worth investing in, all other things being equal, will have a high ROE. While ROE is a great way to know if you're making a good investment in a company, breaking the ratio into its parts can help you understand where company strengths and weaknesses lie.

Profit Calculations

Profitability is among the most important aspects of good business. One of its most common reference measures is net income margin. It's calculated by dividing net income by total revenue. If a company has $100,000 in net income and $500,000 in revenue, its net income margin is 20 percent. In other words, 20 percent of every dollar goes towards net income. The higher the net income margin in terms of business investment, the better.

Asset Turnover

Asset turnover refers to the speed with which assets move in a given period. It's a measure of operational efficiency and speaks to management's ability to run the business. It's calculated by dividing sales by assets. For example, a company with an asset turnover ratio of 0.5 will have a lower ROE than a company with an asset turnover ratio of 2. The asset turnover ratio amplifies net income margin. Keep in mind that asset turnover varies by industry, so what may be good for one company may be bad for another.

Leverage Levels

The more leverage, or debt, a company has, the more risky it is. However, like asset turnover, leverage can boost profitability. It is important to understand what the average leverage ratio is for your particular industry and to use that as a basis for comparison. Common ratios used to measure leverage are debt to equity, debt to assets and assets to equity.