The value of an operating business often depends on two key components: the future economic benefits the business is expected to generate, and the rate of return hypothetical investors require given the associated risks.

Business valuation professionals may use financial benchmarking to better understand a company’s historical performance, expected cash flows, and operating risks. Comparing a business with industry peers and reviewing its own financial trends can help identify factors that may affect value.

Here are four areas valuators commonly review.

1. Growth & Profitability

Valuation experts often evaluate growth and profitability in tandem. Revenue growth, measured from the top line of the business’ income statement, is one common indicator. Consistent revenue increases generally signal lower risk, but if the business sells more without minding its margins, financial difficulties (such as cash flow shortages) may ensue.

Profitability metrics evaluate how much money the subject company earns from each dollar in revenue. For-profit businesses need to earn enough to cover fixed and variable costs, but some may accept a loss on certain products to gain market share or attract customers.

Common profitability metrics include:

• Gross margin [(revenue − costs of sales) / revenue]
• Earnings before interest, taxes, depreciation, and amortization (EBITDA) margin (EBITDA / revenue)
• Profit margin (net income / revenue)

 
Profit margin may be less relevant when benchmarking closely held businesses because it’s hard to compare entities with different tax strategies and capital structures. So, EBITDA margins may be used instead. Before making comparisons, valuators may adjust historical results for nonrecurring or owner-specific items that could distort either measure.

2. Working Capital

Valuation experts also review 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. However, the amount of working capital a business needs depends on its industry, operating cycle, and access to financing.

Conversely, when a business’ current ratio (current assets / current liabilities) is less than one, a line of credit might be needed in case of emergency. A business with above- or below-average liquidity may warrant a valuation adjustment for excess or deficit working capital. It’s also important to evaluate the composition of working capital for uncollectible receivables, obsolete inventory, and shrinkage.

3. Asset Management

Asset management ratios measure how much revenue is generated for each dollar invested in assets. This analysis can be broken down by different asset categories and evaluated in terms of days. For example, an expert might compute:

• Total asset turnover (annual revenue / average total assets)
• Days in receivables [(average receivables / annual revenue) × 365 days]
• Days in inventory [(average inventory / annual cost of sales) × 365 days]

 
Valuators may also consider industry-specific operating metrics. 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 an important asset. Productivity measures can provide insight into operating capacity and risk.

4. Leverage

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, because debtholders are paid before equity investors in liquidation. Plus, interest expense is generally tax deductible, within applicable limits. (Dividends paid to equity investors aren’t tax deductible.)

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. Common leverage benchmarks include debt-to-equity, debt-to-EBITDA, and interest coverage ratios. These measures help valuators assess the business’s debt burden and ability to meet its obligations relative to industry peers.

Putting The Pieces Together

No single ratio determines a business’ risk or value. A comprehensive benchmarking analysis covers all four areas when assessing company-specific risks. Valuators also consider trends over time, along with comparisons against entities engaged in similar business activities. They may use these findings to evaluate management’s financial forecasts or develop discount rates under the income approach. Benchmarking can also be useful when selecting comparables and applying pricing multiples under the market approach. Contact us to discuss how your business’ financial performance and risk profile may affect its value.