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How much is your business worth: Future earnings

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This is the third and concluding article in a series on the most effective strategies for undertaking a business valuation. Having now analysed the best valuation methods for the present day, Kevin Lovewell turns to the final pieces in the financial puzzle: How to find a financial ratio that measures profits.

We have seen that, in light of the many ways to value a business, there are two valuation categories that stand out:

valuation based on the ASSETS of the company (Physical Assets, Book Value, Adjusted Book Value); and

valuation based on the CASH FLOWS the company can provide to its owners (Multiple Earnings, Discounted Future Earnings, Discounted Cash Flow, Capitalised Earnings).

It now remains for us to shed some light on the importance of financial ratios – namely, using an accurate ratio to calculate your business’ profitability.

But first, let’s tie in our valuation analysis with a few words on risk.

Balancing Risk and Return

As future cash flow features prominently in the valuation methods previously discussed, developing an understanding of the “Risks” to future cash flow is an essential step in valuation methods.

For example,

Customers: There are many things about business customers that are uncertain. Are they happy, will they come back, and so on.

Operations: The way you operate determines risk, the assets owned or needed by the business, old equipment such as computers, vehicles, “hand shake” agreements, rights to use something or some process.

Contracts: Once again, this might involve “hand shake” agreements and rights to use something or some process, which might expire soon.

Financial: Debt levels – irrespective of the sources.

Key Players: The business owner who works long hours for minimal wages. (Sound familiar?)

How you assess the risk to future cash flows should be clear.

Ratio Analysis

There are many financial ratios available – entire books full. Over the years, it’s been possible to distill the variations down to a handful. My business, Corporate Solutions, offers four key ratios.

1. Gross Profit Margin %

Calculated from revenue (or sales) less the direct cost of producing the sale, equals gross profit.

Gross profit then divided by Sales:

A B
Sales $45,000 $45,000
Less COGS $26,000 $35,000
(Cost of Goods Sold)
Gross Profit $19,000 $10,000
Gross Profit Margin 42% 22%

In this example, Company A is more profitable than Company B. The reasons could be many, however so long as they are comparable, Company A will always be more valuable than Company B – because it makes more money from selling the products it sells.

2. Net Profit %

The Net Profit % is calculated by dividing Net Profit $ by Sales $

The Net Profit (whether it be “before tax” or “after tax”) is the monies available to be taken by the owners. Net profit is the reason we are in business, so there should be no argument as to the importance of this ratio.

A B
Sales $45,000 $45,000
Less COGS $26,000 $35,000
Gross Profit $19,000 $10,000
Gross Profit Margin 42% 22%
Expenses $8,000 $7,000
Net Profit $11,000 $3,000
Divided by Sales $45,000 $45,000
Net Profit Margin 24% 7%

There may be businesses that make greater profits than others. There may be valid reasons why a profit figure is low or high, and there might be costs that are included or not included. Still, the actual measurement is an important first step.

3. ROCE – Return on Capital Employed

The ratio ROCE is one of the most dynamic ratios used in business analysis. It links the Balance Sheet and the Profit and Loss, measuring the operational effectiveness between them both.

The ratio shows the relationship between Earnings (or more simply Net Profit – or when used by accountants various other “adjusted” bottom lines) and the Assets used to actually achieve the earnings.

Irrespective of the type of industry you occupy, the ROCE should be at least equal to the average interest rate, or if used, the WACC.

The ratio is arrived at as follows: Net Profit / ((Current Assets – Current Liabilities) + Non- Current Assets)

A B
Net Profit $11,ooo $3,000
Balance Sheet Assets $45,000 $55,000
Balance Sheet Liabilities $12,000 $13,000
Balance Sheet Net Assets $33,000 $42,000
Calculated ROCE 33% 7%
(NetProfit / Net Assets)

This ratio when used indicates that Company A is not only getting bigger profits, but needs a smaller investment in resources (the net assets) to achieve those bigger profits.

4. Activity Ratio

Calculated as Sales / Net Assets, this ratio measures how much revenue is gained by the assets needed to gain that revenue.

A B
Sales $45,000 $45,000
Balance Sheet Net Assets $33,000 $42,000
Activity Ratio $1.36 $1.07

Here, Company A produces $1.36 in revenue for every dollar of total capital employed. Company B only earns $1.07 for every dollar of total capital employed.

Company A makes more money, with a smaller investment in assets needed, and provides more cash at the end of the day to the owners.

These four examples have been created to highlight two main points:

  • Firstly, comparisons are important – whether it be comparison of a particular company’s progress over time – trend analysis. Or comparison of two companies, or even comparison with “best practice” “Industry norms” or desired outcomes.
  • Secondly, whatever the derived valuation of a business, it is important to satisfy yourself that the information you have received is meaningful to you.

Conclusion

The essential ingredient when conducting a business valuation exercise is the clear identification of exactly what is being valued. It is important to understand if it is the business, the assets within the business, the proprietorship, future profits, or future cash flows that are being used to estimate “business value”.

Just as important is the fact that all methodologies are opinion-based, despite the very complex mathematical structures that might be used.

The key or primary assets that create value in our economy are now the “intangible assets”, such as people, processes, customers, and innovations.

These things are difficult to measure and manage – but not impossible.

A 2004 KPMG Study of Fortune 500 companies revealed that the companies voted “best to work for”, based on those companies attitude and care for employees and customers, were valued significantly above the market or equivalent businesses, some by as much as 50%.

So, how much is your business worth?

Kevin Lovewell is the owner of Corporate Solutions (Aust) Pty Ltd, a Fellow of the Institute for Independent Business and a CMT accredited Master Mentor.

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