One way to gauge company-specific risk is to benchmark financial performance over time and against competitors. In turn, the risk assessment helps an expert estimate the subject company’s expected return. Here are critical benchmarks that business valuation experts monitor when valuing a private business.
Profitability metrics evaluate how much money the subject company earns from each dollar in revenue. For-profit companies need to earn enough to cover fixed and variable costs, but some may accept a loss on certain products to gain market share or lure customers.
For example, a consumer product manufacturer might not make much money from selling a razor base — in fact, these may be given away for free or for a nominal amount. But the manufacturer makes up for the loss when it sells replacement blades and complementary products with a hefty margin.
Common profitability metrics include:
• Gross margin [(revenue – costs of sales) / revenue], and
• EBITDA margin (earnings before interest, taxes, depreciation and amortization / revenue).
Profit margin (net income / revenue) may be less relevant when benchmarking private firms, because it’s hard to compare companies with different tax structures. So, EBITDA may be used instead. This also eliminates from the analysis the effects of accelerated first-year depreciation deductions for private companies that have recently acquired major fixed assets — as well as the effects of differing interest rates between the subject company and its comparables.
The income statement tells only part of the story. Business valuation experts also spend significant time dissecting the balance sheet, starting with working capital metrics. To the extent that current assets exceed current liabilities, the subject company has extra cushion (or liquidity) to weather short-term cash shortfalls and adverse events.
Conversely, when a company’s current ratio (current assets / current liabilities) is less than 1, a line of credit might be needed in case of emergency. A business with above- or below-average liquidity may warrant an adjustment for excess or deficit working capital. It’s also important to evaluate the composition of working capital for bad debts, obsolete inventory and shrinkage.
Business valuation experts also consider how much revenue is generated for each dollar invested in assets (revenue / total assets). This analysis can be broken down by different categories of assets and evaluated in terms of days (rather than the number of times an account turns over). For example, an expert might compute:
• Days in receivables [(average receivables / annual revenue) × 365 days], or
• Days in inventory [(average inventory / annual cost of sales) × 365 days].
Productivity metrics also can be industry specific. For example, a hospital might be evaluated based on revenue per bed or a hotel based on revenue per room. A labor-intensive manufacturer might be evaluated in terms of output per worker. Human capital isn’t reported on the balance sheet, but it can be a valuable asset.
Debt can be an inexpensive alternative to equity financing that helps the business grow and lowers the cost of capital. Typically, the cost of debt is less than the cost of equity. That’s because debtholders are paid before equity investors in a liquidation. Plus, interest expense is generally tax deductible. (Dividends paid to equity investors aren’t tax deductible.) However, the cost of debt may become prohibitive as the debt-to-equity ratio increases.
For tax years that begin in 2018 or later, the Tax Cuts and Jobs Act generally imposes new limits on interest expense deductions for businesses with annual gross receipts over $25 million. Additional rules and restrictions apply, and there are some exceptions. For certain businesses above this threshold, the change could increase the cost of debt capital.
Borrowing money can be a cost-effective way to grow a business. But there are limits. At some point, the cost of debt capital becomes prohibitive, and creditors may be unwilling to lend additional funds.
It’s all relative
When benchmarking financial performance, what’s “normal” varies depending on the company’s size, industry and geographic location. Business valuation professionals understand these nuances and how they affect a company’s perceived risk and expected return. Contact a trained specialist for more information on how financial benchmarking is used to value a business.