What should you use for business evaluation?

There are various ways of measuring the earnings of a business. And it may seem a bit confusing at first. While selling your business which one should you use for business evaluation?  Let’s look at each of the ways that are used for Small to Medium-Sized Businesses:

  • Net income (NI).

This can also be referred to as net earnings or the bottom line. Basically it’s the income of the business after all the expenses are deducted. This may seem simple enough. But for a large organization this can be a very complicated figure to come up with. Expenses include all taxes and operating costs like:

  • salaries,
  • rent,
  • amortization,
  • deprecation. etc.

This may be regarded by some as the true figure of earnings. But you need to bear in mind that many smaller businesses have mastered the art of keeping the taxes low. Thus it may not always be a good number to rely on.

  • Earnings before Interest and Taxes (EBIT).

This measurement can also be called the ‘operating profit’.  Many view that this gives a clearer idea of the earning potential. This is because it takes out of the equation two variables that can be very dependent on the accounting system and the owner’s preferences.  Both taxes and interest payments can vary according to the financial strategy. This then affects the NI.  Taking these two out gives a fairer figure.

  • Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA).

A further measure of a business takes away the effect of depreciation and Amortization. This figure places the focus totally on the financial outcome of the operating of the company. It also removes non-operating factors which can vary according to management decisions. However, this figure can be quite misleading as the depreciation and amortization can vary according to the business. So it does not always give a good gauge of the earnings.

  • Seller’s Discretionary Cash Flow (SDCF).

When smaller businesses are owner operated, SDCF is commonly used as the measure of the company’s worth.  It is made up of profit before tax and interest and before benefits and one-time expenses. Sometimes the buyer and seller may disagree with what should be included in this figure. So do some discussion to come to an agreement. For instance there may be a discrepancy over a one-time expense.

All these calculation can have their use for business evaluation. A lot depends on the type of business and its size. In general the  EBIT or EBITDA are the most useful ones in order to reflect the earnings.

When you have used one of the methods for measuring the earnings of a busines, it is necessary to understand what   the normal range of multiples is.  The multiple compares the earnings with the Enterprise value of the company.  For a small company the multiple when using SDCF can be 1 -3. But for a medium size company it will be 3 to 5 using EBIT.  The multiple will increase when using EBITDA.  However, all these are just guidelines. The more unique a company is the more likely it will be outside the normal range.  In any case, it is important to understand the limitations of any one way of measuring earnings. And also understand how it has been calculated.  Do not just take the figure at face value. And out of context, but use it as a helpful indicator.

In summary

There are a number of different uses for business evaluation.  There are advantages and disadvantages in each. And sometimes the size or type of business will dictate which one is more appropriate.  However, it is important not to just take these measurements at face value.

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