Can you use financial ratio analysis in business valuation? If done correctly, this could be a helpful adjunct in your valuation. Specifically, reviewing financial ratios could help you spot the company’s strengths and weaknesses, and compare its performance to industry peers.
Here are the major groups of ratios to consider in valuing a company:
- Short-term liquidity ratios such as current and quick ratio
- Activity ratios including the inventory and accounts receivables turnover
- Risk analysis figures such as business risk and degree of operating leverage
- Balance sheet ratios indicating leverage and equity to asset ratios
- Fixed charge coverage ratios, indicating sufficiency of cash flow to cover debt service
- Return on investment ratios such as return on total assets and equity capital
You can take advantage of the financial ratios in your business value analysis in a number of ways. Selecting valuation multiples in calculating the company’s market value is one area. The multiples are typically calculated from a data set based on several comparable companies. Riskier businesses tend to be assigned lower valuation multiples, while the firms with better financial performance could command higher valuations.
If your subject company compares favorably in terms of key financial ratios, its value is likely to be at the high end of the range. For example, consistent, stable history of earnings is a good justification to pick higher valuation multiples based on EBIT or EBITDA earnings.
In general, the higher the level of business risk revealed by your financial ratio analysis, the lower the business value, whether calculated on the company’s revenues, assets, or other financial variables.
You can uncover important trends in company’s financial performance by examining the ratios over time. Such trend analysis can help you demonstrate how the company has improved or fallen back within the period. Since business value is a forward looking concept, such trends help you identify significant business risks likely to impact what the business is worth.
If you need to support your selection of valuation multiples, compare your company’s financial ratios to its industry peers. If the company shows strength relative to others, then higher valuation multiples are reasonable. On the other hand, poor financial performance should guide you to choose lower valuation multiples.