Financial Ratios in Business Valuation
Key Takeaways
- Financial Ratios Drive Business Valuation: Financial ratio analysis is essential in business valuation, helping analysts interpret financial statements and assess company performance.
- Core Ratio Categories Matter: Key ratio categories used in valuation include liquidity, efficiency, leverage, coverage, and profitability ratios.
- Liquidity Impacts Risk and Value: Liquidity ratios evaluate a company’s ability to meet short-term obligations, influencing perceived risk and overall value.
- Operational and Debt Metrics Support Forecasting: Efficiency, leverage, and coverage ratios measure operational performance, cash flow generation, capital structure, and debt-servicing capacity – important inputs for forecasting and valuation models.
- Benchmarking Strengthens Valuation Accuracy: Profitability ratios and benchmarking against peers and historical trends help analysts assess sustainable earnings and develop more objective valuation conclusions.
One of the critical steps to valuing a company is financial statement analysis. A useful tool that valuation analysts use to analyze a company’s financial statements is financial ratios. Financial ratios tend to fall into five categories: liquidity, efficiency, leverage, coverage, and profitability.
Liquidity Ratios
Liquidity ratios, such as the current, quick, and cash ratio, offer insights into the company’s ability to meet its current obligations. Typically, higher liquidity ratios are viewed favorably by investors because they indicate that the company is in good health and generates more current assets than current liabilities. However, it is always good to dig deeper into the accounts that comprise these ratios, because a high current ratio could also be indicative of obsolete inventory, while a high quick and current ratio can be caused by accounts receivable being overstated due to delinquent accounts not being written down. That said, high liquidity ratios for companies properly recording their current accounts can serve to decrease the overall risk of an enterprise which can positively impact its value.
Efficiency Ratios
Efficiency ratios measure how a company utilizes its balance sheet items to drive sales. These ratios include asset turnover, inventory turnover, accounts receivable turnover, accounts payable turnover, and working capital turnover. One of the struggles of a highly liquid company is that they can often stockpile current assets while paying current liabilities in advance. This can create a drag on projected cash flow as a company records sales that are not collected in a timely manner, purchases inventory that is not sold quickly, and pays vendors early.
A complement to efficiency ratios is the cash conversion cycle. The cash conversion cycle is calculated by adding the number of days accounts receivable remain outstanding plus the number of days it takes to sell inventory minus the number of days it takes to pay vendors. Low cash conversion cycles indicate that a company converts its assets into cash quickly and is directly related to a company having high turnover ratios. This can in turn improve the cash flow projections of a company when building out a discounted cash flow model during the valuation process.
Leverage and Coverage Ratios
Leverage ratios help an analyst gauge the extent to which a company’s assets are funded with debt while coverage ratios indicate a company’s ability to service its debt. Ratios that fall into these categories include debt-to-equity, debt-to-assets, debt-to-EBITDA, debt service coverage, and interest coverage. While liquidity is focused on immediate obligations, leverage and coverage are more concerned with structural capital decisions and long-term solvency. However, when evaluating a closely-held private company, leverage ratios can be a misleading indicator. This is because the non-current assets such as buildings, equipment, and intangibles are rarely recorded on a company’s balance sheet at their fair market values.
When a company elects to record accelerated depreciation, leverage ratios can be largely overstated. For this reason, coverage ratios tend to be a better indicator of whether a company is over or under levered when evaluating closely-held private companies. When valuing a business, companies with low leverage and high coverage ratios are viewed as safer. However, businesses that maintain moderate leverage and coverage ratios may be considered optimal because they benefit from using debt capital, which is typically less expensive than equity capital.
Profitability Ratios
Profitability ratios are critical for valuation analysts to be able to understand how a company’s revenues drive overall cash flow. Common profitability ratios are net profit margin, EBIT margin, and EBITDA margin. We find that EBITDA margins are very useful for benchmarking privately-held companies because capital structures and depreciation methods can vary substantially between different companies within the same industry. By stripping out expenses that are non-operational, such as interest expense and removing non-cash accounting decisions, one can better compare a company to its industry or even its own historical performance at times.
Conclusion
When valuing a company, using financial ratios to understand trends, risk, and profitability is an essential step to developing reasonable projections. Benchmarking ratios against industry and historical performance allows for an objective measure of evaluation for a business. The concepts covered in this article provide a high-level overview of how different types of financial ratios can be used to evaluate the performance of a business.
If you have questions related to financial statement analysis within the context of business valuation, or of Business Valuation services in general, please contact T. Eric Blocher CPA, ASA, CVA.
About the Author
Clay joined McKonly & Asbury in 2023 and is a Senior Financial Analyst with the firm. He is a member of the firm’s Advisory and Business Consulting Segment and
provides business valuation and litigation support services. In his role, Clay values closely held businesses in various industries including professional services, real estate,
manufacturing, retail, food services, and others. He has also developed focused industry knowledge providing business valuation services for Employee Stock Ownership Plans (ESOPs), pass-through entities, and family limited partnerships.
Clay also provides transaction due diligence services, buyside and sell-side transaction advisory services, and financial modeling services to assist with investment decisions.