Understanding how the financial performance of a business impacts its value
For a business owner, the desire to grow the business is understandable. However, increasing a business’s sales or revenues is different than increasing its value, or the price a potential buyer is willing to pay.
Business owners are busy and may ask why it is necessary to spend time thinking about increasing the value of the business if they aren’t planning to sell it in the near future? It can be tempting to look at short-term gains versus taking the long-term view, but the business is likely a business owner’s most valuable asset so it’s worthwhile knowing the drivers of value for the company. Business owners should be aware of their business’s performance. Considering the drivers of value in a business allows for improved decision-making to maximize outcomes in the short- term and long-term—or at least enabling owners to stay informed of the tradeoffs.
Financial performance is the first key driver on the list of "Eight key drivers to value a business," a previous article in this Control Engineering series. Business owners are accustomed to watching revenues, but that’s only one part of financial performance and not necessarily the most important. Understanding the power of increasing margins and profits will provide a much larger payback.
Driving value through financial performance
Follow these action items to review a company’s financial performance. Review the company’s last five year-end income statements side by side. What trends are seen with revenues, gross profits and operating expenses?
The following are questions to ask within each category in order to begin an analysis:
1. Are revenues decreasing, holding steady or increasing? Buyers like to see steady, gradual growth—not declining sales, or significant peaks and valleys from year to year.
2. Are revenues repeating, or recurring, from year to year? Recurring revenues can benefit the business now, as well as increase the attractiveness of the business to a potential buyer. This allows for the focus to be on increasing work with existing clients versus always worrying about getting new clients. Does pricing and packaging of services support the goal of securing recurring revenue streams?
3. Are there contracts with any customers that define the length and terms of the relationship? Buyers like contracts, if they are assignable, that help them retain clients and reduce the likelihood that a customer will change the existing business relationship if a change of ownership occurs.
Are the company’s gross profits (revenues less cost of goods sold) increasing as a percentage of sales? Even a 1% improvement in gross profit has a significant impact on value. Here are a few ways to increase your gross profit margin.
- See if it is possible to negotiate for lower cost of services or products delivered.
- Possibly Negotiate with customers to share the cost of freight in or out, or travel expenses.
- Evaluate whether or not inventory turns can be improved.
1. Compare the past five years of operating expenses to identify trends that do not seem reasonable. Take the time to dig in with an accountant to understand what is included in those expenses. If there is an anomaly, the expenses may not be categorized consistently. It could be a non-recurring, one-time expense, or it could be time to speak to a vendor about renegotiating prices. The overall trends tell the story, but just looking at one specific number from any given year will not.
2. Document any one-time events so inconsistencies can be explained to a potential buyer. This exercise also can be assuring that expenses are being categorized properly.
3. The following are questions to ask relating to operating expenses:
- Labor — what are the current market trends? Are you at, or close to, market levels in terms of the team’s size and compensation levels?
- Insurance — how do premiums look compared with the benefits of your plan? Is it time to ask for competitive estimates again?
- Are there expenses to outsource that could save money? Payroll processing is an expense category that is typically better outsourced.
After analyzing the above data, there are other helpful ways for understanding a company’s financial performance:
- Access industry data to benchmark the company’s performance against others. This can be a meaningful way to identify where expenses may be out of sync, relative to revenues.
- Identify if there are certain products or services the company provides that have a very low profit (and not high volume)
- Determine the quality of the company’s financial statements. Do you have a consistent chart of accounts that has a manageable number of separate accounts? It’s best to have enough categories to be able to get the feedback you need to run the company, but not have so much detail that allocating expenses between categories cannot be done consistently.
- Analyze if the financial statements are compiled, reviewed or audited by an outside accounting firm. Buyers prefer to see an outside accountant involved in the preparation of year-end financial statements. Buyers also prefer reviewed or audited statements as these provide some additional assurances that the data is accurate. Consider having reviewed or audited statements completed for the three years prior to selling the business. It’s worth the additional expense.
When the above analysis is complete there should be a better understanding as what a potential buyer looks at. Having a solid understanding of the business’s financial information will help identify opportunities for increasing profits, and therefore increase value.
Catherine J. Durham is accredited senior analyst, principal, and president, Capital Valuation Group; edited by Emily Guenther, associate content manager, Control Engineering, CFE Media, firstname.lastname@example.org.
- How to identify opportunities to increase business value.
- Questions to ask to analyze business performance.
- Analyzing a business’s financial performance.
What would be the best guidelines to measuring financial performance for a new business that has less than five years of financial statements?
Coming soon: A link to part 8 in the Business Valuation Article Series will be offered below.