Procedures for business evaluation are designed to meet certain criteria, beginning with the defining of the allotted task to the conclusion and evaluation of the business. To achieve this, as with managing a successful business operation, structured planning and preparation are called for, with disciplined attention to detail. For an effective evaluation, organization is crucial, with two commencing points being the reason for conducting the evaluation and gathering all needed information.
The evaluation of a business involves the process of determining the worth of that business, a procedure dependent upon two critical elements, commonly referred to as the standard of value and the premise of value. They are reliant on how the business value is determined and the prevailing circumstances. A standard value is also the widely used fair market value term, while the premise of value relates to the sale of a business, with an ownership interest of 100% and a “going concern” status. This translates into a business being sold to the highest and most suited bidder, with the present owner continuing to manage it, under the auspices of the new owner(s).
Knowledge and data collation
Upon knowledge gained of how and under what conditions the worth of a business will be evaluated, the relevant data, crucial to a business value requires collation. It is data that can include:
- Business financial statements
- Marketing and business plans
- Customer and vendor information
- Operational procedures
- Staff records.
The type and quality of the information gathered and presented, has the capacity of demonstrating the quality of the overall business operation, which in turn, reflects on the business evaluation report. Carefully and efficiently presented, well-documented financial statements and tax returns are crucial in demonstrating the earning power and potential of a business. Regular and above the industry norm earnings, have the tendency to motivate a higher business value!
Business operating procedures that are detailed in writing have the affect of creating easier comprehension of the business; duties allocation and the skills in demand. As for any new owner, it is easier to manage an efficiently designed, well organized business. This produces an increased number and degree of buyer interest with competition among them tending to raise the selling price. An effective and realistic marketing plan provides crucial input to projected business earnings, which are a key factor to evaluating the business value, founded on its income. Customer records reveal the sources of income for a business and those not relying on a few large customers for their turnover, are inclined towards a higher selling price.
Financial analysis procedure
While some of the gathered information will offer immediate and constructive parameters for evaluation purposes. Other data, significantly the historical financial statements of a business, will need adjustment, to meet the requirements of the business valuation methods.
The business evaluation procedure is primarily an economic analysis and accordingly, the financial information of a business provides key inputs to the procedure. Two primary financial statements required in business evaluation are the income statement and balance sheet, which to evaluate a small business, demand a history of 3-5 years. Although various small business owners may manage their businesses for reducing taxable income; for the purposes of evaluation, supporting documentation of the full business earning potential is considered essential.
A particular concept in the evaluation procedure is the construction of an accurate relationship between essential business assets, expenses and the levels of income for the business, such assets are capable of producing. It is usual for the balance sheet and the income statement to be restructured, to generate inputs for use in the business evaluation.
Business valuation methods
A market based business valuation method is directed at estimating business value. This is achieved by examining business sale transaction data available from the related marketplace. There are two relevant types of transaction data; namely; guideline transactions related to similar public businesses; and comparative transactions, concerning private companies, with a close resemblance to the subject business.
While an advantage of utilising public guideline business data is its ready availability, there is need for care in the selection and matching of it. When the procedure involves sales of similar private businesses, various and direct means to evaluate the business are available. However, a particular challenge is the gathering of sufficient data to obtain a meaningful comparison.
Irrespective of which market-based method is selected, calculations depend on set, pricing multiples that allow an estimation of the business worth, with comparison to some measure of its business economic performance. The usual pricing multiples utilized in small business evaluation include; selling price to revenue and selling price to business earnings,; for example, net income, net cash flow, SDCF or EBITDA.
A pricing multiple is a ratio of the realistic selling price of a business, divided by the related economic performance value. For the purpose of determining the value of a business, one or more of the pricing multiples may be used.
Business worth, estimated by the earning power of a business, is determined using income based valuation methods. Experts in the business evaluation procedure generally consider these methods the most accurate. It is usual for income-based business evaluation methods, to depend on either capitalization or discounting a certain measure of business earnings. For more details check How to value a small business.
Business worth decision
Once the results are available from the selected valuation methods, a decision can be made as to the worth of a business, usually referred to as the business value synthesis. As no single method of evaluation provides the definitive answer, it is sometimes necessary for the utilization of several results, obtained from various methods, before making a decision regarding business worth.
Another consideration is that as various business valuation methods have been employed, different results may be produced. Therefore, reconciliation of these differences may be required! Experts in business valuation, usually employ a weighting scheme to obtain a conclusion regarding evaluating a business. The weights assigned to the results aspect of business valuation methods, each serve to project their relative influence in attaining this business evaluation.