As both a Certified Valuation Analyst and a Certified Business Appraiser dealing with business valuations for legal matters, shareholder disagreements or positioning of a company for sale, I am commonly asked if a client’s business is under-performing compared to their industry average. Although there are many ways to make this determination, especially through the use of RMA or IRS comparative ratios, most business owners and most business brokers don’t have access to these ratio databases.
As an alternative, a business owner can quickly look at the general Rules of Thumb (ROT) for an industry. ROT’s can be found in one of the latest editions of the “Business Reference Guide”. This publication lists expenses as a percentage of annual sales with a bottom line pretax profit as a percent of sales. If your percentage (pretax profit/annual sales) is below the industry percentage, then your company is under-performing.
If this percentage cannot be found in the reference, then refer to the ROT for revenue verses the ROT for Seller’s Discretionary Earnings (SDE). SDE is equal to the net pretax income plus one owner’s salary. If using the ROT multiplier for revenue is greater than using the ROT multiplier for SDE, then the company is under-performing.
Let’s look at a specific industry…
Industry: Medical Billing – NAICS 541219
Rules of Thumb (ROT):
50-55 percent of annual sales plus inventory (use 52.5% as an average value); or
3 times SDE
Company A: Revenue = $1,200,000 SDE = $185,000
Revenue ROT: $1,200,000 x 52.5% = $630,000
SDE ROT: $185,000 x 3 = $555,000
Because $555,000 (using the SDE ROT) is less than $630,000 (using the Revenue ROT), Company A is most likely under-performing.
Company B: Revenue = $1,900,000 SDE = $310,000
Revenue ROT: $1,900,000 x 52.5% = $997,500
SDE ROT: $345,000 x 3 = $1,035,000
Because $1,035,000 (using the SDE ROT) is greater than $997,500 (using the Revenue ROT), it can be concluded that Company B is performing above the industry average.
Larger companies will be evaluated based upon EBITDA multiples (rather than SDE multiples) in comparison to Revenue multiples by using this same concept of comparing an earning ROT to a revenue ROT.
If your company is under-performing, seek help in addressing this issue as it will most certainly reduce your business value if you are attempting to sell your business. A full ratio analysis will give you even greater detail as to which expenses are hurting your business.
Robert T. Hulet is the Senior Director of Business Valuation Solutions, LLC in Pacific Grove, California. He has consulted over 100 companies throughout the U.S. and Canada. He focuses on business valuations, corporate restructuring, shareholder dissolutions, marital/divorce litigation, strategic planning, budget analysis, operations management, cost/benefit analysis, mergers & acquisitions, business consulting, and educating management & negotiating teams. Mr. Hulet was the President of a multi-million dollar, multi-location U.S. based import/distribution Company. He has also earned four business degrees from the University of Arizona; Accounting, Finance, Management Information Systems, & General Business.