What You’ll Learn
- Why knowing CAPEX, OPEX, COGS, and SG&A matters for business planning.
- How Add Backs affect Seller’s Discretionary Earnings (SDE) when buying/selling a business.
- How to interpret key financial metrics like CAGR, IRR, and MOIC for better decision-making.
- Overview of Balance Sheet, Income Statement, and Cash Flow Statement.
- Understanding metrics like DSCR and WACC for financial planning and loans.
Thinking of buying a business? Or maybe you just bought one? Then, it’s good to know some money words and what they mean for your business.
For example, words like “CAGR,” “IRR,” and “MOIC” are what people look at when they want to give you money for your business or when you want a loan from the bank.
Knowing these words is like having tools in a toolbox. They help you make good choices, talk to people about money, and see how your business is doing.
Knowing what “Add Backs” or “Seller’s Discretionary Earnings (SDE)” are can help an owner evaluate the true cost of purchasing or selling a business. Terms like “CAPEX” and “OPEX” help distinguish between types of expenses, aiding in more accurate budgeting and forecasting.
These terms help in understanding and preparing important financial statements like the Balance Sheet, Income Statement, and Cash Flow Statement, which are vital for both internal decision-making and external reporting.
Therefore, being well-versed in these terms equips small business owners with the knowledge to operate efficiently and enhances credibility and decision-making in the business environment.
Here is a look at some common business, financial, and accounting terms.
| Add Backs | Add Backs are adjustments made to Seller’s Discretionary Earnings (SDE), usually reducing it. In theory, SDE is the profit that remains in an owner-operated business after the deduction of all expenses except taxes and interest on debt. That’s the theory. In practice, it is usually necessary to adjust SDE to remove extraordinary personal expenses (health club membership, car), extraordinary business expenses (one-time legal expense), and an owner salary that is out of line with market salary for the work they perform (it may be lower or higher than the fair market salary that you would pay someone from outside the company). Acquira’s Quality of Earnings services can provide valuable insight into the true cost of buying a business, including addbacks. |
| Business Segments | This term tends to confuse because it can refer to a breakdown of business activity by (1) industry segment, such as plumbing vs. HVAC in the same company, or (2) type of job, such as new construction vs. residential services, or residential new system installation vs. repair and servicing. Whatever the case, it’s important that you know figures like COGS and SG&A by business segment, in order to have a better idea of where your profits come from. |
| CAGR (Compound Annual Growth Rate) | This is the mean annual growth rate for some specified period that is greater than a year. Here’s an example, looking at EBITDA as it changed over 24 months: … a company has $100,000 in EBITDA on December 31 of 2019. But on December 31, 2020 EBITDA decreased to $88,000 (a decrease of 12%) as a result of COVID closures, while on December 31, 2021 it increased to $109,100 (an increase of 23.98% on the previous year; let’s round that to 24%). The average annual return on EBITDA was (-12% + 24%)/2, or 6%. But 6% per year means EBITDA of $106,000 at the end of year 1, and $112,360 at the end of year 2, which is wrong, since we know EBITDA was just $109,100 at the end of year 2. To get an accurate picture, we use CAGR, which takes the nth root of the total increase (or decrease) over a period n: here, n is the number of years in the calculation. In the example above, n = 2, so we take the square root of the EBITDA at the end of two years. The return over two years was $109,100/$100,00, or 9.1% and its square root (ie., for two years) is 4.45%. |
| CAPEX, Capex (Capital Expense); Float | CAPEX, or Capex, is short for Capital Expense, as opposed to OPEX (Opex), which is Operating Expense. These are funds required to maintain, upgrade, or acquire physical assets, such as property, technology or new equipment. They will be recorded, or capitalized, on a business’s balance sheet rather than being expensed on its income statement. Items recorded as Capex have a useful life of more than one year. They include expenditure to increase the life of an existing asset, but also to increase the scope of a business’s operations. |
| COGS (Cost of Goods Sold) | COGS refers to the direct costs of producing the goods or services sold by a company, both in materials and labor. It excludes indirect costs, such as overhead on rent and utilities, advertising, dispatch, HR, and accounting. COGS is deducted from revenue/sales to arrive at gross profit and gross margin. |
| Current Assets, Current Liabilities | The Current Assets account is a balance sheet line item listed under the Assets section, which accounts for all company-owned assets that can be converted to cash within one year. Current Assets typically include cash, cash equivalents, accounts receivable, and inventory. The Current Liabilities account is a balance sheet line item listed under the Liabilities section which accounts for all company financial obligations that are due to be paid within one year. Current Liabilities typically include accounts payable, short-term debt, the current portion of long-term debt, dividends, and taxes. |
| Current Ratio | The Current Ratio is Current Assets divided by Current Liabilities. |
| DSCR (Debt Service Coverage Ratio) | The Debt Service Coverage Ratio is a measure of a business’s available cash flow to pay current debt obligations. Current debt obligations include loan principal and interest, and often lease payments. The formula used may vary somewhat, but is broadly defined as EBIT or Operating Profit divided by Current Debt Obligations. |
| Depreciation | Tangible, or physical, assets lose value as they depreciate over time. Depreciation is an accounting method that spreads the cost of an asset over its expected useful life (in equal amounts, or not, according to the type of depreciation used). The entire cash outlay may be paid all at once, and this is reflected on the balance sheet. Each year thereafter that depreciation expense is recorded on the income statement it reduces the business’s taxable income. The IRS publishes depreciation schedules showing the number of years an asset can be depreciated for tax purposes, based on various asset classes. |
EBITDA (Adjusted) vs. SDE | Adjusted EBITDA is a financial metric that incorporates the removal of various one-time, irregular, and non-recurring items from EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). The purpose for adjusting EBITDA is to get a normalized number that is not distorted by irregular gains, losses, or other items: these may include items like non-cash expenses; one-time gains or losses; litigation expenses; special donations; and above-market owners’ compensation, etc. Adjusted EBITDA is the same as SDE to which the appropriate add backs have been made. |
| EEVC (Enterprise Value to Equity Value Conversion) | Acquira uses this as a multiplier to convert the fraction of purchase price paid by a minority investor to the fraction of ownership which they receive in exchange. For example: assume majority and minority investors collectively put $280k, or 10%, down on a $2.8mm deal. The majority (or active) investor pays $112k and the minority (or passive) pays $168k. The minority, passive investor has paid $168k out of $2.8mm as a down payment: that’s 6%. The EEVC is 250%, which converts the 6% to 15%, which is the percent ownership that the passive investor gets. Note that the majority, active investor retains 85% ownership in this example, so stands to get much more out of an eventual, successful exit. |
| Financial Statements … | |
| … Balance Sheet | The Balance Sheet gives a snapshot of your financials at a specific moment, such as year-end. It incorporates every accounting journal entry since the business was launched (although the Balance Sheet does not show these entries specifically, just their results). It shows the business’s assets (what it owns), liabilities (what it owes) and what money is left over for the owner’s disposition (owner equity). |
| … Income Statement (aka P&L) | You might see the Income Statement referred to as a Profit and Loss (P&L) Statement. Sometimes, P&L is misleadingly used to refer to all three main financial statements: the Balance Sheet, the Income Statement, and the Cash Flow Statement. The Income Statement is usually produced monthly, and aggregated for each quarter and year. It subtracts from the business’s revenues for the period all expenses, including COGs, SG&A, interest, depreciation, and taxes. |
| … Cash Flow Statement | The Cash Flow Statement summarizes the movement of cash and cash equivalents into and out of the company over a given period. It measures how well a business generates cash to fund its operating expenses and pay for its debt obligations. |
| … Pro Forma Statements | Pro Forma Financial Statements are projections of a business’s future expenses and revenues, based on its past experience. They are frequently included in the business plan that an investor draws up prior to acquiring a company, and incorporate the investor’s plans for readying the company for growth. |
| …Free Cash Flow (FCF) | Free Cash Flow can be calculated as Cash Flow from Operating Activities + Interest Expense – Tax Shield on Interest Expense – CAPEX. Note that big swings in capital expenditure from year to year may make the trend line of FCF more lumpy than it would otherwise be. |
| …Profit | Profit is the financial benefit realized when revenue generated from a business activity exceeds the expenses, costs, and taxes involved in sustaining the activity in question. . The different categories of profit shown below are listed in the order that they appear on the Income Statement. |
| … Gross Profit | Gross Profit is Sales minus the Cost of Goods Sold (COGS). |
| … Gross Profit Margin | Gross Profit Margin is Gross Profit divided by Sales. |
| … Operating Profit | Operating Profit removes operating expenses like selling and overhead as well as accounting costs like depreciation and amortization. It is sometimes referred to as earnings before interest and taxes, or EBIT, and may be called Operating Income. |
| … Net Profit | Net Profit is at the bottom of the Income Statement, hence “the bottom line”. It is Operating Profit less interest and taxes. |
| Intrinsic Valuation of a Business | The Intrinsic Valuation (or Value) of a business is its true value as measured by objective calculations performed on its fundamentals, not its price on the market. |
| IRR (Internal Rate of Return) | IRR is not an easy concept to grasp intuitively. It is the discount rate that makes the net present value of a project equal zero. Net Present Value (NPV) is the difference between the present value of cash inflows and present value of cash outflows over a period of time. The Internal Rate of Return is when the initial project cost, paid up front, is exactly offset by the present value of future cash flows. IRR takes into account the differing timeframes in which the specific inflows and outflows occur. For example, a dollar of profit realized five years following the initial investment into a project is worth less than a dollar realized just one year into that project. |
| MOIC (Multiple on Invested Capital) | MOIC calculates the return on invested capital, whether realized or not, although Acquira typically uses it in the realized sense. It may take you five years to achieve a MOIC of 5x (eg., $1,000,000 on your initial investment of $200,000), or perhaps ten years. IRR, on the other hand, cares about how long it took you: a MOIC of 5x after five years represents an IRR of 37.9% (annually), while a MOIC of 5x after ten years represents an IRR of 17.4%, still a terrific return, but less so. |
| OPEX, Opex (Operating Expense) | OPEX, or Operating Expense, is frequently considered to be the same as SG&A and is usually not considered a part of COGS. See SG&A for details. |
| SG&A (Selling, General & Administrative) | SG&A Expenses is a line item in the Income Statement which includes almost all business costs not directly attributable to making a product or performing a service. The G&A part of SG&A Expenses are known as overhead. Selling Expenses include compensation and benefits for sales people, marketing, and advertising. In most cases SG&A is synonymous with Operating Expenses. Note that the other major expense category is COGS, or Cost of Goods Sold. |
| WACC (Weighted Average Cost of Capital) And CC (Cost of Capital) | The Cost of Capital is used to make a decision as to whether a projected capital spending decision can be justified given its cost. Capital, as described here, may be derived from debt or equity, or some combination of the two. Weighted Average Cost of Capital (WACC) expresses, in a single number, the return that both bondholders and shareholders demand in order to provide a business with capital. A high WACC often signifies that the market for the company’s shares, bonds, or other debt considers its capital to be higher risk. The WACC is often used to calculate the Hurdle Rate, which is the minimum rate of return required on an investment or project, given its cost of capital and the comparative returns expected from competing projects. |
| Working Capital | Working Capital is a financial metric that represents the operating liquidity available to a business. It is calculated as current assets minus current liabilities. Working Capital is managed by paying close attention to cash, accounts receivable and accounts payable and inventories. |
Conclusion
The world of business acquisitions and entrepreneurship is fraught with complexities, especially when it comes to financial jargon.
A comprehensive understanding of key financial and accounting terms and metrics is indispensable for small business owners looking to navigate this landscape effectively.
Knowing the nuances between CAPEX and OPEX, COGS and SG&A, and metrics like IRR, MOIC, and CAGR, among many others, provides a competitive edge for business planning, evaluation, and growth strategies.
These common terms not only help in efficient internal management but are also vital when engaging with external stakeholders such as investors or financial institutions. They serve as the backbone for critical financial documents like Balance Sheets, Income Statements, and Cash Flow Statements that reflect the health of the business.
Whether you are buying, running, or selling a small business, mastering these terms can significantly enhance your decision-making capabilities and overall business acumen.
If you’re a budding entrepreneur looking to learn more about these common financial and accounting terms, consider joining our premier MBA-level M&A program, The Accelerator. This comprehensive training equips you with all the essential skills and knowledge you’ll need to successfully acquire a business in just seven months. The program features a vibrant community of like-minded entrepreneurs, expert guidance from Acquira’s dedicated team, and access to top experts in the field of acquisition entrepreneurship.
However, slots are limited. To check your eligibility, just complete the form below, and we’ll get back to you shortly.
Key Takeaways
- Knowing how to properly account for “add backs” can significantly affect a company’s valuation during a sale.
- A high Debt Service Coverage Ratio (DSCR) can make your business more attractive to lenders and investors.
- Mastering cash flow statements can provide insights into the operational efficiency of your business.
- Being familiar with your Weighted Average Cost of Capital can guide you in making sound investment decisions.
- Understanding SDE can offer a clearer picture of a small business’s actual profitability, valuable both for current operation and for potential sale.
Acquira specializes in seamless business succession and acquisition. We guide entrepreneurs in acquiring businesses and investing in their growth and success. Our focus is on creating a lasting, positive impact for owners, employees, and the community through each transition.
