SME Lending – Business Valuations
There are many specific times in a SME’s life that determining the business’s value is important. Whether it’s applying for a loan, raising investor finance, selling or transferring ownership, without a business valuation it is difficult or impossible to proceed.
Regardless of where a SME is in its business cycle or maturity, undertaking a business valuation provides a great opportunity for a financial health check and to assess potential business growth. Obviously, valuing a business involves the collection and analysis of financials, however, it also requires control over emotions. Owners of family businesses and/or those running their first business typically have no experience or comparisons to call upon. As a business finance professional, you can be of great value to SMEs in regard to business valuations by ensuring that an objective approach is used and a realistic and accurate value is reached.
Valuation Methods
Business valuations take into account factors such as assets, liabilities, income and expenses along with the economic conditions and the environment in which the SME operates. These factors are sourced from Balance Sheets, Profit and Loss Statements and from Tax Returns. The information is used to determine a SME’s value or total worth.
As a business finance professional, you should understand the different methods and formulas for calculating a business’s value and be confident in coming up with a value independent of the owner’s or lender’s figures.
There are three methods that are considered relevant for business valuations, especially when it comes to finance and lending. A single method is rarely used and all methods should be considered and compared to come up with as accurate a valuation as possible.
1. Net Asset Valuation
This is the easiest and most straightforward method. By subtracting existing liabilities/debts from business assets such as property, plant and equipment, inventory, cash and accounts receivable, you arrive at the net asset value.
For example, if the SME has $660,000 in assets and $180,000 in liabilities, the net asset value would be $480,000.
2. Capitalisation Rate
This is the most common method to value SMEs. It uses the net profit (or net operating income) of a SME and a rate of expected return from investment in the SME given the risk to the income, of the SME (the capitalisation rate).
The first step is to determine the SME’s net profit. This is usually done by averaging the last three years of profit as detailed in the Profit & Loss statements. It is sometimes appropriate to subtract irregular or one-off expense items and adjust the profit figures accordingly.
The next step is to estimate the capitalisation rate and this takes into account the current risk-free rate of return (what an investor would get by putting ‘money in the bank’) and a risk premium appropriate to the SME being valued. The risk premium factor caters for the degree of risk in a SME and can be approximated by comparing the SME to similar businesses in the industry and environment in which the SME operates.
For instance, the capitalisation rate for a coffee shop would take into account and compare the average net profit of similar-sized coffee shops in similar locations.
Finally, to arrive at a valuation figure divide the net operating income by the capitalisation rate and multiply by 100.
For example, if it is determined that the capitalisation rate for a coffee shop is 12.5% and the average net operating profit over the last three years is $60,000; the valuation would be $480,000 ($60,000/.125).
A variation on this method is multiple of earnings. Instead of using Net Operating Income (NOI) this method uses Earnings Before Interest and Taxes (EBIT). The difference between these is that EBIT takes into account depreciation and amortisation expenses. Using EBIT would be a better valuation method for SMEs that have high levels of depreciation on their books. For example, a trucking company with a fleet of its own vehicles.
3. Comparable Sales
This is where, as a business finance professional, you would look at sale valuations on businesses similar to the SME that are in a similar location. For example, the sale of a coffee shop in the same street as the one being valued. Typically, things are not that easy and you might have to broaden your search to find comparable SMEs.
It can also be crucial to account for differing economic conditions. For example, the valuation for a trucking company that works in the mining industry during a recession would not compare to the sale value of a similar trucking company during a resources boom (all other things being equal).
Other Valuation Considerations
There are a host of other factors and questions that come into play when calculating business valuations. They include: -
Accounts Receivable – how well is the SME managing fee collections and timely invoice payments?
Contracts – is the SME is reliant on a small number of key client contracts and if those contracts are nearing the end of their contractual terms what impact will that have?
Suppliers – what is the potential impact on a SME from its suppliers changing terms or charges? Can the SME source different suppliers?
Rent – where a major part of SMEs expenses is rent what are the terms of the rental or lease agreements? Are there years left on the agreement, is there an option to renew and if new leasing agreements need to be put in place how will they compare to the existing costs?
Business Plan – how well does the SME know its Strengths, Weaknesses, Opportunities and Threats (SWOT Analysis)? What is the competitive environment and what analysis has been undertaken to counter competitive forces? Are then any political, economic or industry trends that could affect the SME?
From a lending perspective, the valuation methods used and the other factors that can be considered will make a difference to the loan amount offered and the interest rates and fees applied to the loan.
Business valuations are based on the principle of what is the SME worth today (not in the future). However, business valuation shouldn’t only be undertaken for sale events. Having an accurate figure that a SME owner is confident in, can crystallise thinking and be the catalyst for decision making and the exploration of opportunities
And if lending and financing are part of your work with SMEs, an appropriate and current business valuation will make the application process infinitely easier.
In conjunction with industry experts, elevateB has developed a self-paced, online, interactive Business Finance Certification. This program will provide you with the knowledge and skills required to become a successful Business Finance Professional and work in the SME space. In addition, it provides strategies and soft skills to assist you to better market and deliver your existing and new-found client offerings.
For more information on the Business Finance Certification, click here.