If I offered to sell my company, you would inquire "Is it worth it?" Well, financial metrics come into place. Financial experts consider financial indicators to formulate the relationship between a company's ownership value and the worth of a market. This gets them estimates of the company's profitability and financial status.
Valuators use SDE, EBITDA, Free cash flow, and other financial metrics to calculate a business's worth. Although some financial indicators aren't relevant to all businesses, understanding them plays a key role in improving the assessment process and increasing its value.
Valuing is an essential aspect for businesses, and when it is time, they generally expect an accurate value and a valuator with the know-how and expertise to cover every aspect. To give the best business valuation, an appraiser must avoid common evaluation mistakes and use the various metrics available.
16 Financial Metrics Essential to Valuators
With financial metrics, it is easier to value or monitor a business, and there are so many that I can only cover some of them in this article. Below is a short list of a few essential ones that any valuator must know.
EBITDA Metric
EBITDA, a key metric, measures a business's earnings before interest, taxes, and non-cash expenses like amortization and depreciation. It's beneficial for calculating a business's core operations earnings, as it doesn't consider the tax environment, asset base, and capital structure costs.
Ebitda is the common profitability metric for businesses that operate with a management team and would be acquired by investors.
Seller's Discretionary Earnings (SDE) Metric
SDE shows the total earnings from the business that flow back to the seller (owner) such as the owner's salary and personal use of an automobile.
SDE is the common profitability metric for businesses that are owner-operated.
Free Cash Flow Metric
During an appraisal, the valuator must evaluate the free cash flow to understand a business's financial flexibility. This metric shows how much money is left after deducting all the running expenses, indicating how much money is available for the company to invest, reduce debts, or pay investors.
Free cash flow differs from operating cash flow or net income, and it indicates how much money is left for the company to do as it pleases. It’s an important metric to know as some businesses may have a high ebitda which does not account for necessary capital expenditures, such as replacing equipment.
Gross Profit Margin Metric
To get an accurate valuation, the appraiser must show whether the business is making or losing money and needs to calculate its gross profit margin. The evaluator figures out the gross profit margin. It does this by taking away the product cost from the net sales.
By looking at the profit number, the evaluator can assess a business's profitability and compare it to similar firms to determine its worth.
Average Invoice Processing Cost Metric
Every business must pay suppliers, and this is called the "Average invoice processing cost," which valuators consider during the valuation process. Valuators use this metric to determine how much a business spends to pay its bills.
A low invoice processing cost shows that the company efficiently pays suppliers. The expenses cover fees, postage expenses, and more.
ROS (Return on Sales) Metric
During the valuation process, the appraiser calculates the business's ROS (Return on Sales) to see how much money it makes after deducting all operating costs, known as operating income. Operating income shows revenue turned into profit and indicates a business's efficiency.
Net Profit Margin Metric
An essential part of an evaluation is calculating a business's profit after deducting operating expenses, goods sold, taxes, and interest. "Net Profit Margin" refers to the remaining money after subtracting all the operating costs.
Inventory Turnover Metric
A vital value indicator I must highlight is a business's inventory turnover, which shows how fast the company replaces or circulates its inventory. A slow turnover indicates slow sales or the business is buying too much inventory, and either one shows that the company is not functioning at its capacity.
A fast inventory turnover can also negatively affect a business's value. While a fast turnover generally indicates good sales, it can also mean that supplier or availability issues affect a company's profitability.
Operating Cash Flow Ratio Metric
A valuation examines every financial aspect of a business, including its OCF (Operating Cash Flow Ratio). OCF is cash made by the business from operating activities that the company uses to pay short-term (12-month period) debts like accounts.
OCF is calculated from the business's cash flow statements, not its balance sheet or income statements, to remove operating expenses paid by other income streams.
Working Capital Metric
Working capital compares assets like cash and other outstanding money due to the business against expenses like accounts and debts the business must pay. Assessing a company's capital is crucial for understanding if it faces challenges in fulfilling its financial commitments.
Current Accounts Receivable Ratio Metric
A business's value relies heavily on its ability to collect outstanding invoices. A business's current accounts receivable ratio considers several factors, including the company's billing terms. The appraiser examines the current and outstanding invoices to determine the amount paid on time versus those overdue.
Current Ratio Metric
A company's value depends on its ability to generate profit, which includes increasing its current ratio. Every business has current liabilities like accounts payable within a year and current assets like cash and inventory receivable within a year.
As a valuator, I compare the business' short-term assets and liabilities during the valuation process to determine whether it has enough convertible assets to meet its financial obligations.
Quick Ratio Metric
A business must be able to convert assets into cash to meet its short-term obligations. One option is to convert liquid assets into cash without disregarding their value.
The quick ratio is like the current ratio, but it only considers liquid or cash assets and excludes accounts receivable and inventory that are difficult to liquidate quickly. A high quick ratio adds to a business's value.
Leverage Metric
Many businesses borrow money to buy or finance assets, known as "leverage." Few appraisers consider leveraged assets when valuing a company, significantly impacting the value. If a business has a lot of leveraged assets, it is at higher risk.
Debt-to-Equity Ratio Metric
Appraisers must examine a business's debt-to-equity ratio and how it will impact its solvency if something goes wrong. During a valuation, I investigate the SE (Shareholder's Equity) to see if it will cover the debt if the company has nosedived.
Total Asset Turnover Metric
I believe a business's asset turnover is one of, if not the most significant, factor to consider during a valuation. The total asset turnover shows how fast a business generates revenue with its assets. The company's health and value increase as the faster turnover generates more money.
Conclusion
Countless things impact a business's value, and l want to emphasize that appraisers must consider every aspect when calculating its value. Even though most evaluations adhere to standard procedures, it's critical to comprehend the various metrics and their uses.