Deciphering the Key Financial Metrics of a Business's Value
Clean financials and detailed records provide a major leg up to anyone selling a business. And as a buyer, it’s crucial to understand how to best approach a seller’s financials and recognize the metrics that matter most when valuing a business.
It helps to realize that financial metrics are just information. It’s how you use that information that really matters in a potential acquisition.
Consider these three ways to put the financial information you obtain to best use when evaluating a business for sale.
1. Look at the long-term trends.
At the top line of a P&L, too often in online business, buyers tend to become easily distracted by the short-term picture. It’s easy to look at the last 12 months of revenue and form an opinion based on what you see there. But that’s an incomplete picture. A longer-term, year-over-year comparison will yield much more interesting and accurate results.
How are revenues holding up over time? A year-over-year analysis will allow you to see patterns of seasonality to a company’s sales, but more importantly, you’ll see direction. If you really want to know where a business is headed, performing a long-term trend analysis is essential.
Is the rate of growth holding steady? You may have a steady rise in revenue over the short term, but still have a decrease in the growth rate in sales from one year to the next. That would indicate a problem.
Are revenues keeping up with costs? Plot the gross margins over time, and compare them from year-to-year to see how the profitability of this business is trending. Gross margins under 20 percent indicate a risk you may not be willing to take. And if the percent change in gross margins is trending down from one year to the next, you’ll have questions to ask about pricing and profitability. For some product-based businesses, price competition can be a killer.
2. Look for anomalies, and use them to get the whole story.
Moving beyond revenue, you want to be able to break down expenses in as much detail as possible while still keeping an eye on the big picture. Look for spikes, sharp drops and any other anomalies that stand out across time. These will guide your discovery and lead you to ask the right questions.
What’s the story behind a sudden increase in legal or professional fees? What necessitated an increase in wages? Does that increase indicate an effort at growth for the company, and did it pay off? What does a spike in ad spend indicate, and what were the results?
A story of a business is told in its financials, and for you, the buyer, to get the whole story, you have to ask the right questions. For instance, in an ecommerce business, when Facebook implements a dreaded new algorithm change, that’s an event that will probably show up on the books. Looking back, you’re likely to see a change in allocation of funds around that time to reflect a change in the company’s customer acquisition strategy.
Look for the anomalies, and seek out the information around those anomalies that tell the complete story of that business during that time. Your job as a buyer is to minimize your risk by uncovering the whole story. The financials reveal events that will influence your experience as the owner of this business if you buy. Look closely as those events provide critical information going forward.
3. Look for opportunities.
As a seller, transparency with the details of your business will greatly increase trust with potential buyers and therefore increase value. Mistakes and financial losses won’t always deter an experienced buyer, but may stand out to those buyers as opportunities. Many buyers are looking for areas of under performance that they can capitalize on with an influx of the new resources they’ll bring to the table.
As a buyer, it’s a good idea to train yourself to look out for those opportunities. They might come in the form of mistakes -- failure to plan ahead for an expense or a pricing strategy that failed. Or they might show up as hidden profit potential.
One thing that we often see at Quiet Light that will artificially suppress Seller’s Discretionary Earnings, and sometimes spell massive potential, is a company in a growth phase launching new products while at the same time keeping accounting records on a cash basis. In that case, the investment has already been made and massive ROI may be waiting just around the corner.
On the other hand, for a business experiencing a slow-down where financials are kept on a cash basis, the Seller’s Discretionary Earnings may be inflated -- by hundreds of thousands of dollars in some cases -- and that could major mean loss to a buyer.
For anyone valuing a business, it’s hard to overstate this fact -- the better you can determine and analyze the complete picture of a company, looking beyond short-term wins to the long-term direction of profitability and growth -- the better you’ll position yourself to make a sound decision regarding the investment at hand. Learn to look past summary numbers, like top line revenue, and break those numbers down into their constituent parts. Business is a numbers game, after all, and the more skilled you are at reading the numbers in an acquisition, the more likely you are to win big.