Business valuation: using financial ratios

You may have run across a number of financial ratios in trying to analyze a company’s overall performance. The ratios are useful in a number of situations when the company’s financial condition, profitability, and efficiency in using its assets need to be understood.

Using the ratios can help shed light on such important issues as the company’s ability to meet its obligations, its capital structure, how well it uses its resources to generate income, and how profitable it is.

When used properly, the financial ratios can be a useful tool in your business valuation. The obvious benefit is that they can help you spot the company’s strengths and weaknesses and compare it to its industry peers.

Reviewing well selected ratios can help you in your valuation work in a number of ways. Perhaps the most useful area is the selection of appropriate valuation multiples that help you establish the company’s value in relation to its financial performance measures. Valuation multiples are usually derived from comparable business sales, affecting competitor businesses. As a result, you have a statistical range of multiples to choose from.

If the company you value outperforms its peers in terms of profitability, then a higher valuation multiple can be in order. In general, the lower the degree of risk factors that the financial ratios reveal, the higher the company’s value is likely to be relative to its earnings, equity value, and other financial variables.

To pick the right valuation multiple, you would compare the company to its competitors. Areas of relative strength would help you justify a valuation multiple in the high end of the statistical range.

Another way to use ratio analysis is to compare a company’s own figures over time to see if there is a trend. You can spot areas that point up improvement or worsening in company’s performance. This can help you in selecting the discount and capitalization rates most appropriate for your company valuation.

Private company financial statements often require adjustment before you can proceed with business valuation. Be sure you are using the financial ratios consistently. Adjustments for inventory, nonrecurring expenses or discretionary items can greatly affect the ratio figures. When using financial data from an industry sector, be sure your company’s financial statements are adjusted consistent with the industry norm.

Which financial ratios you choose for your business valuation may differ depending on your industry. In general, you should take a close look at the ratios that differ significantly from the industry norm.

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