Multiples and Ratios
This article will expand on some of the information presented in previous articles, and focus on what types of debt and growth targets you should aim for, and what type of margins or other financial ratios are acceptable for your business. Below are some of the main points covered.
Margins and Profitability: How to analyze your income statement and determine what type of margins you should maintain, and how favorable your profitability ratios are.
Debt: Determining the appropriate level of debt based on common financial ratios, and comparing your debt levels to industry peers.
Cash Flow: How to manage your cash flow by ensuring you correctly manage your accounts receivable.
Liquidity: How to ensure your business can use its assets to meet short-term debt obligations.
Selling your business: An overview of common multiples that are used to value businesses in a variety of industries.
Average Margins for Different Businesses
Rising inflation has created a dilemma for many companies, who now need to decide how to pass rising costs onto companies to maintain favorable margins. Many companies in the United States, including publicly listed companies, are experiencing shrinking margins due to rising inflation. Below are some of the common margins that you can examine and compare to your peers. It can also be very helpful to compare your margins over a 5-year basis and see what areas have been improving, and what new problems have arisen.
If you are trying to decide what an acceptable gross margin is, it is best to compare them to the industry average. Although 30% is considered an average gross profit margin, the exact number can vary substantially in different industries.
If you decide that you need to raise your prices to combat rising costs and margin tightening, it is best to look at industry data to make sure your cost increases are in line with averages. You can find industry data in reports on inflation for products like food and apparel, for example. Moreover, you may be able to visit competitors’ websites or stores to see if you notice any significant price increases.
Unlike the gross margin, the operating margin is also highly dependent upon actions taken by management, as it also accounts for the cost of labor, office expenses, and other common operational expenses. Consequently, this is one of the best ways to see how management is working to improve a business and to operate more efficiently. Businesses can also improve their operating margin by reducing waste activity in the organization.
Net Income Margin
The net income margin is one of the most important profitability ratios and shows how much money your business has after it has paid its COGS, operating expenses, taxes, interest, and accounted for depreciation. This ratio is equivalent to the company’s net income divided by its total revenue.
Net Income Margin= Net Income/ Revenue
This ratio provides a balanced view of how successful a company is running. If the ratio is not favorable for some reason, a business can then look at other items, such as operating expenses and COGS, and determine what changes need to be made. Furthermore, non-recurring events, like rapid depreciation or one-time expenses, can cause businesses to have a lower net income margin in one year, although this is by no means a reflection of their long-term prospects.
If you want to determine appropriate margins for your business you can either compare your margins to the average for your peer group or your historical ratios.
1) Peer averages
It can be very useful for businesses to look at the average margins of companies positioned in the same industry, as margins can vary substantially by industry. Below are the average margins for larger listed companies in the United States. Industries like apparel, financial services, and software typically have higher margins.
|Average Gross Margin
Source: NYU Stern
You can also look at your income statements for a 3-5 year period, and compare your margins to previous years. This method can be very helpful, as you can identify one or two specific issues that may result in a lower net income ratio ( ie. rising input costs and rising labor prices).
Multiples Selling A Business
If you are planning to sell your business, there are many different ways you can choose to value your business. Some of the most common ratios that investors focus on are ratios that show your business’s value in relation to revenue, earnings, and EBITDA. Two of the most common multiples that businesses will rely on include the EBITDA multiple and the seller’s discretionary earnings.
SDE: Data from Reliant shows that smaller businesses with revenue below $5 million typically sell at 1.5-4.0x SDE, with an average SDE of roughly 3. SDE is slightly different than net income because you add back other expenses like the owner’s salary, depreciation, amortization, and other non-recurring expenses.
Earnings Multiples: For simplicity, you can also value your business based on earnings, and businesses typically sell at a higher multiple if it is based purely on net income. Most businesses can be sold for 3-4x earnings, depending on the type of industry they operate in and historical financials.
Revenue: Finally, businesses can be sold based on their revenue. Most companies are sold at a discount to annual revenue ( price/sales <1), although this ratio can be higher for certain industries like financial services and insurance agencies.
EBITDA Multiple: Another very common way to value a business is based on a multiple of the company’s EBITDA. Private companies can sell from anywhere between 2-10x EBITDA, and the multiple can depend on a variety of factors. One of the first things someone may look at is the average EBITDA multiple of the sector, and how the company compares to its peer group. However, other factors may influence the valuation, such as historical growth, liquidity ratios, and the amount of debt the company has. The average EBITDA multiple for most private companies is around 4x, so this is a good place to start if you are thinking about how much you can sell your company for.
ROE by sector
A company’s return on equity ( net income/equity) is an excellent indicator of how profitable and efficient a company is. The average ROE can vary depending on the sector and is typically higher in sectors like financial services.
|Business and Consumer Services
|Automotive Dealers/Service Stations
Source: Stern and Ready Ratios
You can also look at other benchmarks, like the S&P 500, which has an average ROE of around 9.8%. In general, a double-digit ROE is very attractive.
Another important decision for businesses to make is how much debt they should take on. Businesses can make this decision by examining their debt relative to peers in the industry, and also taking a closer look at ratios like the debt-to-equity ratio and debt service coverage ratio. Both of these ratios look at a company’s debt, in relation to equity and cash flow, to determine if a company’s financials are healthy. If you are selling your business, the buyer will likely prefer a business with a more favorable D/E or DSC ratio.
The debt-to-equity ratio shows how much debt a company has compared to equity, and is a simple way to examine how leveraged a company is. It is typically best to keep your debt/equity ratio below 2.0x, but many companies may even be better off keeping this below 1. A D/E ratio of 2 indicates that a firm gets two-thirds of its capital from debt and one-third from equity. Some industries, like the services industry, may have a lower debt/equity ratio because they have fewer assets. For perspective, the average DE ratio of the S&P 500 is 1.6.
While having a higher debt/equity ratio can be a great way to fuel greater growth in the short term and increase your equity in the future, it can also increase your business risk. On the other hand, being too conservative and having gearing that is below the industry average can lower your company’s growth potential.
Debt Service Coverage Ratio
Another debt ratio to look at is the debt service coverage ratio, which shows how your operating income relates to your monthly debt payments. This ratio can help you predict how much of a shock you can absorb while still making payments on all of your debt. In order to calculate this formula, you take your operating income for a period and divide it by your interest payments during that same period. A debt service coverage of 1 indicates that a business is at risk of defaulting on its debt. It is best to have a DSC ratio of 2 or higher to minimize your risks, and many banks may be looking for this amount when you apply for a loan.
Most Relevant Liquidity Ratios
In general, the current ratio and quick ratio provide the best indication of how effectively a business is able to meet short-term debt obligations. The cash ratio is also reliable but does not provide a full picture, as it only includes the businesses’ cash and cash equivalents.
Current Ratio: The current ratio is based on your current assets and current liabilities, and shows how likely your business is to pay off all debt due in 12 months or less. It is best for all businesses to ensure that their current ratio is 2 or higher if possible, as this will provide more flexibility if they have trouble selling some assets, or have to sell them at a discount. Moreover, accounts receivable count as a current asset, so any issues with accounts receivable could cause short-term liquidity issues. Anything below 1.0x should be a source of concern.
Quick Ratio: The quick ratio, which is also called the acid test ratio, could be a better indication in some cases, as it focuses on liquid assets. To calculate the quick ratio, you can the value of your company’s liquid assets and divide it by the current liabilities, which are due in 12 months or less.
ROIC and your WACC
The ROIC, which divides the company’s net profit after tax by the invested capital, shows how effective the company’s investments are. The formula is based on the company’s operating income, minus the amount of taxes that it pays.
One of the best ways to determine if a company is effectively creating value is to compare the ROIC to the company’s weighted average cost of capital. The weighted average cost of capital shows the average interest rate on all of your loans and weighs each type of debt by its share of your total debt. If the company’s ROIC is higher than the WACC, then this shows that the company is creating value. It is typically best for your ROIC to be 2 percentage points higher than your WACC.
Comparing both of these figures is useful because certain businesses pay different amounts of interest rates on their debt. Moreover, as interest rates continue to rise, small businesses that have variable loans or are securing new loans will have to develop new strategies to boost their ROIC in order to justify debt-based expansion.
Growth and other considerations
Looking at your company’s historical revenue growth, along with guidance for subsequent years, is a great way to see how your business is performing. If you want to focus on other factors, such as rising inflation, you can also look at the growth of other figures, like your gross profit or operating margin.
Another metric that you can examine, especially if you are planning to hire in the future, is your average revenue per employee. Typical ranges can be anywhere between $43,000-250,000 per employee, depending on the industry and the size of the company. However, if your company has been growing rapidly in previous years, it can be helpful to look at this historical average and calculate the forward revenue per employee during the upcoming financial year.
Accounts Receivable Turnover
Another useful ratio for businesses to monitor is the accounts receivable, which shows how quickly a business is able to collect its accounts receivable balance from its customers. Sometimes when a company sells a customer a product, they can allow them to pay over a short period of time, like 30-60 days. This can create a difference between the company’s reported revenue and earnings, and the cash flow, as the company may not receive the full payment until a later date. This ratio can be calculated on a monthly, quarterly, or annual basis.
Accounts Receivable Turnover Ratio= Net Credit Sales/ Average Accounts Receivable
A higher ratio is positive and indicates that a company collects its receivables quickly and/or primarily deals in cash sales. The only downside to having a high accounts receivable turnover ratio is that your company’s credit policy may be too conservative, and could potentially drive away potential customers. On the other hand, a low accounts receivable turnover ratio indicates that you may have cash flow issues, and may have to spend time ensuring that customers do not forget to pay.
Most companies have an accounts receivable turnover ratio between 5-17, and retail and utility companies typically have the highest ratio. It can also be helpful to offer incentives for early payment, such as discounts, and to develop a system to proactively manage receivables. Having a higher accounts receivable balance can help you gain more revenue, and also have more collateral if you apply for a loan if your accounts receivable balance is listed as an asset on your balance sheet.
Categorised in: Investments
This post was written by Sean Allaband