Utilizing Benchmarking for Informed Business Valuations & Quality of Earnings Reports
Benchmarking, the practice of comparing a company’s financials to those of industry peers and its historical performance, can yield valuable insights into future performance and potential risks. By employing various types of benchmarks, business valuation professionals assess company-specific risks and determine the target company’s potential returns.
Profitability Metrics
Profitability metrics are critical in evaluating how efficiently a subject company generates earnings from its revenue. For-profit businesses must ensure that their earnings cover at least both fixed and variable costs. Some businesses may even accept losses on specific products to gain market share or attract new customers, as a result, it is important to understand the financial performance of the entire organization.
Common profitability metrics include gross margin (revenue less costs of sales divided by revenue) and EBITDA margin (earnings before interest, taxes, depreciation, and amortization divided by revenue). Net income margin may be less relevant in benchmarking private companies due to differences in tax strategies (sole proprietors, LLCs, S corp., etc.) and capital structures, making EBITDA a more suitable alternative. EBITDA is commonly used for comparisons as it does allow for a more direct comparison between these structures and removes the majority of differences in financial presentation.
Liquidity Assessment
Valuation experts routinely analyze a company’s balance sheet, starting with working capital metrics. If current assets exceed current liabilities, the subject company enjoys a liquidity cushion to withstand short-term cash shortfalls and adverse events. This can be critical in more volatile industries where revenues fluctuate heavily due to the industry or other factors.
Conversely, if a company’s current ratio (current assets divided by current liabilities) is less than 1, it might require a line of credit in case of emergencies. Companies with above or below average liquidity may need valuation adjustments for excess or deficit working capital. It is also crucial to assess the composition of working capital for factors like bad debts, obsolete inventory, and shrinkage.
Asset Management Evaluation
Asset management ratios provide insights into how much revenue is generated per dollar invested in assets. This analysis can be broken down by different asset categories and evaluated in terms of days as well for certain comparisons. For instance, experts may compute metrics such as days in receivables [(average receivables divided by annual revenue) multiplied by 365 days] or days in inventory [(average inventory divided by annual cost of sales) multiplied by 365 days].
In certain industries, asset management ratios can be specific to the industry you are operating in. For example, hospitals might be evaluated based on revenue per bed, hotels on revenue per room, or labor-intensive manufacturers on output per worker. Human capital, though not on the balance sheet, is an essential asset that should also be considered and can be thanks to the help of valuation professionals as each situation is unique and requires different considerations to establish an accurate value.
Leverage Considerations
Debt can be a cost-effective alternative to equity financing, aiding business growth and reducing the cost of capital overall. Typically, the cost of debt is lower than the cost of equity, as debtholders are prioritized in a liquidation, and interest expenses are generally tax-deductible.
However, borrowing has its limits. Excessive debt can lead to prohibitively high costs of debt capital, making creditors hesitant to provide additional funds. Finding the right balance between debt and equity financing is crucial for sustainable growth. The acceptable levels of debt also fluctuate between industries, but in any situation excessive debt can be detrimental to key financial ratios.
How NAFA Can Help
Benchmarking financial performance requires a unique approach to each situation and it relies on understanding the nuances of a company’s size, industry, current market conditions, and location. By leveraging the benchmarking methodologies included in this blog and many more, NAFA’s business valuation professionals can provide your business with valuable insights into your company’s performance and value. To learn more about how financial benchmarking is used in business valuation and our quality of earnings services, please contact a NAFA office.