I have a friend in the baseball business who used to value players. He could take a player’s statistics, compare them to other similar players, and help his clients (the baseball clubs) come up with a value range for the player. He knew how to measure things, and more importantly, and he knew which metrics mattered.
So what metrics matter for your business?
1. Year-over-year revenue growth, generally over at least three years. It’s not for nothing that revenue is listed first on an income statement.
As with most metrics, there is no magic hurdle. But 5% annual growth means something, and growth above 10% annually puts your company in a class above most others.
2. EBITDA. I then flip down to the bottom of the income statement and look for a measure familiar to those who talk to outside investors: EBITDA. This acronym, which stands for earnings before interest, taxes, depreciation and amortization, measures approximately how much of the cash flow generated by the business is available to be financed. Earnings are crucially important, but financing sources want to see earnings before non-cash items (like depreciation) and before financing costs (they will figure out the financing themselves). Investors figure out how much a company is worth based on multiples of EBITDA. So they might say your company is worth four times EBITDA or that it’s worth eight times EBITDA.
EBITDA isn’t usually on a small company’s income statement—it has to be calculated. Investment professionals and lenders spend a lot of time figuring out adjustments to EBITDA by backing in (or out) one-time events. They’re trying to determine a company’s consistent cash flows. They know that two things can happen to EBITDA: It’s either going to go down to pay off a lender, or it’s going to be valued by the next investor when they buy the company.
EBITDA also gives an investor a feel for the cushion, or margin of error, that the business has built up. Companies with miniscule EBITDA usually can’t absorb a negative shock unless they have cash on their balance sheet. Companies with more EBITDA are basically generating their own cash.
Two other metrics, both derived from EBITDA, also matter: free cash flow (EBITDA minus capital expenditures) and EBITDA margin (EBITDA divided by revenue). Financiers worry about free cash flow, because companies that require more capital expenditures have to use their earnings to finance those expenditures. The EBITDA margin tells the financing source what percentage of your revenue is financeable. Things start to become appealing to an investor once EBITDA margins start rising above 10%.
3. Customer concentration. I then try to figure out what’s behind a company’s revenues, keeping an eye out for customer concentration. This figure isn’t listed in the financial statement, but entrepreneurs still need to watch it carefully. How much of your revenue is derived from your first-, second- and third-largest customers? Do you get more than half your sales from those three? Is one customer so important that they are driving the success (or failure) of your business? Are your major customers all in the same industry? Or do you benefit from having customers in diversified industries—customers who may all have different reasons for buying from you? If your revenue is concentrated, what is the nature of your relationship with your big customers—Do you have long-term contracts with them, and do they consider you business-critical?
As with all financial metrics, these variables interact. Companies who have battled through flat or down years and maintained their EBITDA have shown that they can adapt their cost structures to changing dynamics. Investors tend to like companies who can keep their free cash flow steady even if EBITDA drops. Companies that grow year-over-year through a downturn in the economy are attracting customers—and they may choose to cut their EBITDA margin in these periods, reasoning that they are taking market share from their competitors, and figuring that they will come out stronger on the other side.
Even if you are not currently seeking financing, make the time to familiarize yourself with these metrics. They’ll help you measure the strength of your business, and stay a step ahead.