Avoiding Confusion – Defining Key Financial Terms

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Oftentimes in finance, professionals use “finance speak” amongst each other so they can communicate quickly and effectively. That’s great, but for someone who is coming from a different industry, you may not pick up on the acronyms and the lingo. And if you’re preparing your business for sale, or you’re going through the selling process, we thought it would be a great idea to list out some of these financial terms, for educational purposes. We want the sellers we work with to feel confident in the sales process, whether that’s the preliminary research or understanding the negotiations taking place with the buyer.

Acronyms

CAGR – Compound Annual Growth Rate Is the rate of return (RoR) that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each period of the investment’s life span.

 CIM – Confidential Information MemorandumIs a document drafted by an M&A advisory firm or investment banker used in a sell-side engagement to market a business to prospective buyers. These documents will contain important financials, future growth projections, customer diversification, strength and weakness analysis, and more.

COGS – Cost of Goods SoldThis is the total amount your business paid as a cost directly related to the sale of products. 

DD – Due DiligenceIs an essential activity in M&A transactions. In the M&A process, due diligence allows the buyer to confirm pertinent information about the seller, such as contracts, finances, and customers. By gathering this information, the buyer is better equipped to make an informed decision and close the deal with a sense of certainty. Due Diligence usually commences after the LOI is signed.

DPO – Days Payables Outstanding Is a financial ratio that indicates the average time (in days) that a company takes to pay its bills and invoices to its trade creditors, which may include suppliers, vendors, or financiers. It’s a measure of cash flow, and you’d like to have cash coming in faster than it goes out, in effect creating a positive cash flow engine.  Many companies get in trouble, even when they’ve secured large, lucrative customer contracts because they’re locked into paying their suppliers weeks and sometimes months before they get paid. 

DSO – Days Sales Outstanding Is a measure of the average number of days that it takes for a company to collect payment after a sale has been made. It’s vital that sellers identify and employ creative ways to get paid faster. For example, you can require upfront customer deposits, receive payments in advance of service, offer discounts to pay annually versus monthly, and more.  The goal is to increase your cash velocity so you’re receiving cash quicker than you’re paying it out.

EBIT – Earnings before Interest and Taxes Is an indicator of a company’s profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.

EBITDA – Earnings Before Interest Taxes Depreciation & Amortization Is a measure of a company’s overall financial performance and is used as an alternative to net income in some circumstances. This is the number that a multiple is attached to for business valuation.

Financial Terms

EV – Enterprise ValueIs a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization. Enterprise value is a popular metric used to value a company for a potential acquisition.

GAAP – Generally Accepted Accounting Principles –  Are standards that encompass the details, complexities, and legalities of business and corporate accounting. The Financial Accounting Standards Board (FASB) uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices. Also, when you have an audit firm audit your financial statements, they will design their audit using GAAP as the basis for their audit procedures.

GL – General LedgerIn bookkeeping, a general ledger, also known as a nominal ledger, is a bookkeeping ledger in which accounting data is posted from journals and from sub-ledgers, such as accounts payable, accounts receivable, cash management, fixed assets, purchasing, and projects.

IOI – Indication of InterestThe IOI is an informal notice of an investor’s interest in purchasing or acquiring an asset, in this case, your business. It is non-binding and is less definitive than the LOI.

KPI – Key Performance Indicator A quantifiable measure of performance over time for a specific objective. KPIs provide targets for teams to shoot for, milestones to gauge progress, and insights that help people across the organization make better decisions. 

LBO – Leveraged BuyoutIs one company’s acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.

Also read: How To Sell Your Business | The Ultimate 2022 Guide

LOI – Letter of IntentIs a written, non-binding document which outlines an agreement in principle for the buyer to purchase the seller’s business, stating the proposed price and terms.

M&A – Mergers & AcquisitionsThis is a general financial term that describes the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions. At Final Ascent, our M&A advisors work with our middle-market business owners, taking them through the selling process and helping them achieve their American Dreams.

NDA – Non-Disclosure AgreementIs an agreement in contract law that certain information will remain confidential. It prevents buyers from disclosing private information about your company.

PA – Purchase Agreement Outlines the buyer’s offer price, along with contingencies, financing terms, closing costs, possession date, buyer and seller representations and warranties, and more. 

P&L – Profit & LossIs a record of revenue and expenses incurred by a business in a given period of time. A profit and loss statement is also called a P&L, an income statement, a statement of profit and loss, an income and expense statement, or a statement of financial results. The goal for any business owner is to have more revenue than expenses, referred to as Net Income, versus the opposite situation where you’re operating at a Net Loss.

PE – Private Equity –  Typically refers to investment funds, generally organized as limited partnerships, that buy and restructure companies.

QofE – Quality of EarningsIn order to get comfortable with the disclosed earnings reported by a seller, a potential buyer engages with a reputable CPA firm to prepare a Quality of Earning Report.  The results of the report are relied on by the buyer and validate the earnings stream of the seller’s company for the last two, three years, in order to understand the revenue stream, the expense stream, and what that means for the underlying company. A QoE report has become the standard versus requiring companies to get a financial statement audit.

SBA Loan – Small Business Administration LoanRefers to small-business loans partially guaranteed by the U.S. Small Business Administration and issued by participating lenders, usually banks. SBA loans have tight lending standards, but their flexible terms and low-interest rates can make them one of the best ways to finance the acquisition of a business.

SDE – Seller’s Discretionary EarningsThis is a calculation of the total financial benefit that a single full-time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Seller’s Discretionary Earnings is measured by EBITDA and adding back (“add-backs”) company owner’s salary, compensations, personal owner expenses, and non-recurring, one-time expenses. To summarize: SDE = EBITDA + Owner’s Compensation + Add Backs. 

TTM – Trailing Twelve MonthsThis is the financial term for the data from the past 12 consecutive months used for reporting financial figures.

VC – Venture Capital – This is a form of equity financing where capital is invested in exchange for equity, typically a minority stake, in a company that looks poised for significant growth.

Lingo

Accrual Basis An accounting method that recognizes income at the time the revenue is earned and records expenses when liabilities are incurred regardless of when cash is received or paid. When a company is marketed for sale, buyers expect the financial statements to be prepared using an accrual basis.  Why is that? Accrual-based financials can be compared to other company’s financials within the same industry and across markets, making it easier for buyers to decide which company or companies they’d like to potentially purchase.

Add Backs This is an expense that will not be included in the buyer’s future P&Ls for the company. Understanding and applying add-backs and other kinds of adjustments help normalize a business’s earnings on a go-forward basis. This will give all parties a true understanding of the seller’s cash flow, and therefore, the true value of the company.

Financial Terminology

AggregatorAn aggregator is a buyer who looks to purchase or consolidate companies within the same industry.

Asset SaleInvolves the sale of actual assets of a business—usually, an aggregation of assets—as opposed to shares of stock and can be a complex transaction from an accounting perspective. An asset sale is classified as such if the seller gives the buyer control of the property after payment is made.

Also read: How to Sell a Software Company? The Ultimate 2022 Guide

Balance Sheet This is a financial statement that reports a company’s assets, liabilities, and shareholder equity. The balance sheet is one of the three core financial statements that are used to evaluate a business. It provides a snapshot of a company’s financial position (what it owns and owes) as of the date of publication.

BenchmarksAre industry standards, or guidelines, for key financial metrics. Basically, they represent the average of key numbers and performance metrics collected from many different businesses and then sorted by industry.

Bottom LineRefers to the profit of a company, also referred to as net income or net profits

Built to SellA business that incorporates all the factors that a buyer is looking for from the beginning of the business. Companies that are built to sell are in a great position to attract multiple buyers, creating buyer tension (see definition below) as buyers compete to own the company, maximizing the sale price at exit. 

Buyer TensionPart of the competitive bidding process, where buyers are constantly given deadlines to move through steps in the M&A sales process. The more buyers who are interested in a seller’s business, the more buyer tension is created, creating a lucrative environment for a seller.

Cash BasisRefers to a major accounting method that recognizes revenues and expenses at the time cash is received or paid out. This is not the preferred method of accounting when you want to sell your business.  Refer to the accrual basis definition to learn about why this method is what buyers are looking for.

Cash FlowRefers to the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. The goal for any seller is to create a positive cash flow engine for their company, where cash is coming in much faster than it goes out.  Buyers look for companies in this situation because they know they can grow and scale the business without having to inject a lot of cash.

Comps Comps is shorthand for comparable, which is a way to conduct a business valuation. M&A advisors and business brokers analyze several business sale transactions, reviewing companies that are comparable in size and have similar financials. Based on their analysis, they use the results to come up with a multiple to find out the enterprise value of a company.

Competitive Bid ProcessA bidding process between buyers where the buyers are given deadlines to make bids on a company and are unaware of who they are competing with. This brings maximum value to the seller. 

Concentration IssuesCan be with customers or suppliers where critical functions of the business may be too concentrated on just one supplier, or customer. This can expose the company to risks unknown at the time. This is known as customer concentration or supplier concentration risk, and buyers are wary of these situations.  They think, “What if the business loses a critical customer or supplier? How will that affect revenues or the company’s ability to procure critical products or services?”  If these risks are present, buyers will oftentimes walk away or reduce their bid price to account for the risk.

Debt CoverageAbility to cover the interest payments on debt used to buy a business.

Current Ratio – It’s current assets / current liabilities.  This is important as a metric on whether a business is bankable – banks typically like to see a ratio of 1.6 or higher.

Dry PowderSimply refers to the cash on hand a buyer has that it can use to fund acquisitions. 

EarnoutRefers to a pricing structure in mergers and acquisitions where the sellers must “earn” part of the purchase price based on the performance of the business following the acquisition.

Equity Market CapitalizationRefers to the total dollar market value of a company’s outstanding shares of stock. Commonly referred to as “market cap,” it is calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share.

Gross MarginRepresents each dollar of revenue that the company retains after subtracting the direct labor and materials used to produce the revenue (referred to as Cost of Goods Sold or COGS). 

Inventory Turnover Is a measure of the number of times inventory is sold or used in a time period such as a year. It is calculated to see if a business has an excessive inventory in comparison to its sales level. 

Key employeeIs an employee with major ownership and/or a decision-making role in the business. They may also lead key functions of the business, like sales, finance and accounting, research and development, and more. Key employees are usually highly compensated either monetarily or with benefits, or both. Key employees may also receive special benefits as an incentive both to join the company and to stay with the company. 

Liquidity Refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Cash is the most liquid of assets, while tangible items are less liquid, like buildings or land. 

Ready to SellA business that is strong in all the areas a buyer is looking for and is ready to go to market. This also applies to the business owner, as they must be just as ready as the business is. 

Recurring Revenue Is the portion of a company’s revenue that is expected to continue in the future. Unlike one-off sales, these revenues are predictable, stable, and can be counted on to occur at regular intervals going forward with a relatively high degree of certainty. Examples of recurring revenue streams are cellphone contracts, magazine or newspaper subscriptions, clothing boxes delivered to your door, Netflix contracts, Amazon Prime memberships, and more.  Businesses that have sales with more than 50% recurring revenue are highly sought after by buyers, and businesses with greater than 90% of their sales are recurring revenue enjoy higher multiples than their counterparts.

Roll-upA company buys multiple businesses in the same industry, consolidates them, and then sells them later for a higher multiple or takes them public.

Multiple A multiple is a number attached to a company’s EBITDA that gives the buyer and seller a valuation range for how much the company is worth.

Seller Note – This is a form of financing used in small company sale transactions whereby a seller agrees to receive a portion of the acquisition proceeds in a series of debt payments. 

Strategic Shorthand for a strategic buyer. A strategic buyer is a company that acquires another company in the same industry to capture synergies. Because a strategic buyer expects to get more value out of an acquisition than its intrinsic value, it will usually be willing to pay a premium price to close the deal.

Stock Sale A company’s shareholder sells their existing stock to a new owner. In this transaction, the buyer obtains all company equity including all assets and liabilities. This means the buyer is at risk from future litigation from liabilities that are not paid and cleared.

Financial Terms and Definitions

Subscription Revenue This can be defined most simply as a model which generates income from customers through recurring fees that are paid at regular intervals. These can be weekly, monthly, or annual payments. 

Term Sheet This is a nonbinding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.

Top Line Refers to the revenue of a company.

Working Capital This is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. In its simplest form, working capital is calculated as current assets minus current liabilities.

Also read: How to Mentally Prepare to Sell Your Business? | Top 6 Ways

Working Capital Calculation Is calculated by taking a company’s current assets and deducting current liabilities. For instance, if a company has current assets of $100,000 and current liabilities of $80,000, then its NWC would be $20,000. Common examples of current assets include cash, accounts receivable, and inventory. Examples of current liabilities include accounts payable, short-term debt payments, or the current portion of deferred revenue. 

You ProofYou proof your business so it’s not dependent on you. Buyers are looking for businesses that are not owner dependent, so in order to increase your business attractiveness, you’ll want to be less owner dependent.

These are all financial terms we come across every day in the M&A industry. By learning and understanding these terms, you will have leverage in conversations during the sales process. If you have any questions or would like to add some of your own knowledge, feel free to drop a comment below!

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