When heading to the doctors for an annual checkup, we are reminded to know our numbers –cholesterol, blood pressure, heart rate, and BMI – to ensure our heart health. The same applies to your business and its financial health. When is the last time you had a business checkup and discovered the current value of your business? Do you know the vital signs and KPIs (key performance indicators) of your business?
Knowing your numbers is vital so you can take meaningful actions to improve your business’s health and grow its long-term value. To achieve this, it’s important to step away from working in your business and start working on your business to help define its future path to increase value for all its stakeholders.
Overview of business valuation
A periodic valuation of your business can provide vital insights and benefits. The value of a business plays a fundamental role in making future business decisions and guiding financial planning. The process helps crystallize all elements of your business and provides a roadmap for growth.
With the knowledge of your business’s value – which is a function of both its performance and current market trends – you can decide if it’s time to grow into a new market, acquire additional businesses, raise debt or equity capital, or maybe even sell at a larger premium.
There are three forms of value that are used in business transactions:
Asset value – When valuing the entire company (100% control interest), it is typically necessary to distinguish between the value of "assets.” Calculation: Value of inventory plus value of FF&E plus value of intangibles.
Equity value – Involves the full transfer of the legal entity including current tax attributes. Buyer operates business from historical legal entity. Calculation: Asset sale value plus liquid financial assets less liabilities.
Enterprise value – A reflection of the firm’s value as a functioning entity and is helpful in that it facilitates the comparison of companies with varying levels of debt. Calculation: Equity value plus long-term debt less cash.
A business valuation must distinguish between smaller, single owner-dependent businesses and larger, middle-market businesses with layers of management using seller’s discretionary earnings (SDE), i.e. a distinction is made between a return on owner’s labor perspective and a return-on-investment perspective.
SDE is calculated as the sum of pretax income and a series of add backs such as owner’s salary and payroll taxes, owner’s perks, depreciation and amortization expense, interest expense, and any one-time, non-recurring expenses. Valuations must incorporate SDE, as well as a forward looking variant of net cash flows to invested capital and discounted cash flow analysis. This dual method is necessary in order to properly value both the typical owner-operated business on Main Street as well as investor-owned high-tech or high-growth enterprises.
A successful business owner can think in terms of desired outcomes and articulate the operations of the business in industry-tailored metrics. The art and science of calculating the numbers and translating them into insight and action is a critical skill of any successful entrepreneur.
There are a number of important levers that you can pull to increase the value of your business, so it’s vital you know where you stand. These levers, or KPIs, serve to help business owners know where to focus and how to prioritize actions based upon the impact to value.
Interest coverage - Pretax income plus interest expense divided by interest expense.
Fixed assets turnover - Total revenues divided by fixed assets.
Receivables conversion - Accounts receivable and total revenues.
Inventory turnover - Total revenues divided by inventory.
Return on equity - Pretax income and total equity.
Debt-to-equity - Total liabilities divided by total equity.
Cash-to-debt - Cash divided by total liabilities.
Income to revenue - Pretax income divided by total revenues.
Cash flow to revenue - SDE divided by total revenues.
Receivables to income - Total accounts receivable divided by pretax income.
Inventory to income - Total inventory divided by pretax income.
Fixed assets to income - Total fixed assets (book value) divided by pretax profits.
Total debt to income - Total liabilities divided by pretax income.
It is also helpful to benchmark your company’s performance in these KPIs to other unique industry peers. This will help guide you where the greatest relative improvements can be made and in turn how they will drive growth in business valuation.
Access to capital
Capital is the life blood of growing a business. As a business owner and entrepreneur, building a successful business hinges just as much on your core products and services as it does on your ability to raise capital.
The optimal capital structure will ensure the business owners achieve the highest return on their equity while running the business. The time to raise equity is when your business value is relatively high or when you’ve achieved an important milestone, from which you can use the proceeds to pursue the next plateau.
The appropriate level of debt is a function of the market value of the business, which isn’t often known by its owners. This shortcoming often leads to the owners making decisions that are not optimal or possibly not in their best interest, and often leads to tying up personal assets to help support the business.
Conclusion – Enabling growth in your business’s value
If you’re a public company with shares that trade on an exchange, you can see your business’s market value quickly and easily via your mobile phone. Calling you on that same phone are likely investment bankers pitching M&A ideas and several debt or equity alternatives to finance company initiatives.
Our valuation platform, in consultation with one of our experienced relationship bankers, allows you to leverage your business’s success and value with innovative ideas to enable growth strategies, including:
Financing for permanent working capital needs
Refinance other bank debt
Refinance or shareholder note
Freedom Bank recognizes the need to continuously monitor and optimize a business’s worth and put real-time business valuation within the reach of all business owners, in essence bringing Wall Street insights to Main Street. Visit freedom.bank/business-valuation and begin your check-up today.
Please Note: E-mail is not a secure form of communication. Please do not send any confidential information using this form. This includes account numbers, social security numbers and password or PIN information.