The key success of your business lies in seizing the right opportunity and at the right time. However, you cannot simply seize the right opportunity if you are not prepared with the right tools at hand. Whether you’re calculating your move to utilize an upcoming opportunity or want new investors, or simply want to sell your business, there will come a time when you need to calculate your organization’s economic worth—in other words, business valuation.
In this article, we will learn about business valuation in-depth and understand the three primary methods of evaluating your organization’s financial position in the current market. Let’s delve deeper into the subject!
What is Business Valuation?
Business Valuation is an essential yardstick that helps you calculate your organization’s financial standing at any point in a financial year. Valuation is a crucial step required at the time of merger, takeover, or sale of the business.
What is the Purpose of Business Valuation?
Now, once you understand why business valuation is necessary, it’s time you know the “why” of such calculations. Briefly, there are a handful of reasons why business owners are required to evaluate their organization’s worth. A few of them are:
- When trying to sell your business.
- While merging or acquiring any other notable organization.
- When looking for investors to finance your business.
- While laying down norms for partnership.
- Including shareholders in the firm.
- For specific tax evaluations.
Different Methods to Evaluate your Business
When determining the current value of your firm, you will come across multiple methods to help you out in the process. Similar to how we have various reasons behind carrying such evaluations, there are numerous ways to maintain such valuation methods to calculate a fair estimate of the business or its assets.
However, in this article, we will be confined to the three primary approaches that are widely used to evaluate an organization’s worth:
- Asset-based approach:
The asset-based business valuation represents a total of all the investments held by the company.
There are two ways to evaluate using the asset-based approach:
- Using the company’s balance sheet where the organization sums up the total assets of a business, subtracted by its total liabilities. This process represents the book value.
Assets- Liabilities = Book Value
- The second step involves a liquidation asset-based approach, where we calculate the organization’s liquidation or net cash received after its assets are sold and liabilities settled.
However, things can be different if you’re a sole proprietorship; using the asset-based approach in such instances can be difficult. Assets of a sole proprietor are in the owner’s name, and differentiating between the real and personal support in such cases can be difficult.
- Earning value approaches
Now, our other approach, the earning value approach, is a calculation based on probability. The idea here is to calculate output in terms of the organization’s ability to produce wealth in the future!
Capitalizing the overall earning determines the expected levels of income, using its past earning records.
Here’s an example of how the process goes:
If your business had an income of $1 million the previous financial year, its average cap rate would stand at 5%, as per industry standards. To calculate its future output, you need to divide the profit by 5%, making it $20 million in this case ($1 Million/ 5% = $20 Million).
Interestingly, things get tricky for you if your business is a sole-proprietorship one. The current valuation of a service-oriented business needs to include an estimated percentage, which the business might lose under a change of ownership.
- Market value approaches
The market value approach represents a comparison of your organization’s value in terms of a company that has been recently sold. The idea here is similar to methodologies used in real estate. However, the factor is limited to specific businesses.
Yet again, assigning a specific value to your sole proprietorship business can be a tricky part! As per its definition, a sole proprietorship business is owned by an individual, making it tough to find information on sales on other similar companies.
Remember, validating the current worth of a business depends on multiple factors like the essential factors, working knowledge, experience, and professional judgment.
Which Valuation Approaches Should be Utilized?
With all the information and the assumptions that we have in place, the analysis leverages the valued approach selection. The market, income, and cost approaches are the most commonly used valuation approaches.
Selecting any one of the suggested methods is based upon your accessibility of information, knowledge of the business, and revenue, among other information.
The Bottom Line
Even if you don’t plan to raise investments or sell your business any time soon, it is always a positive aspect to have a comprehensive valuation of your organization. This way, besides serving you at times of financial emergency, the valuation will help you track the overall business process and success.