Joining the family business: a successor’s guide to understanding financial information

We know that family businesses are great at taking a longer-term outlook – and that extends to helping their potential successors to learn about all the various aspects of the business operations.

But what we’ve also heard from those in the Next Generation considering whether to join the board is that understanding how to read and interpret the financial information may not receive quite the same level of attention. We’ve heard of newly appointed directors being asked to vote on crucial and potentially big number decisions but without having had much help understanding what the financial reports or projections actually mean. For example, understanding the Balance Sheet, Profit or Loss Statement, and Cashflow Statement, and what a ‘good’ set of financial statements looks like.

And yet this is vital in order to make relevant and informed decisions, to understand the competition, as well as ensuring that your family business remains financially ‘healthy’. In the words of one of the FBU champion’s at last year’s conference, “Keep close to the numbers.”

Deciding whether to take over the family firm involves careful consideration of various financial indicators to assess the company’s current health and future potential. In addition to the annual financial reports, these are some of the key financial indicators to bear in mind:

Profitability: how much money is the business making?

• Gross Profit Margin: Indicates the percentage of revenue that exceeds the cost of goods sold. A higher margin suggests better efficiency in production or service delivery.

• Net Profit Margin: Measures the percentage of revenue that remains as profit after all expenses, including taxes and interest. It reflects the company’s overall profitability.

Liquidity & cash flow: how much cash is the business generating? Is there a cash flow problem?

• Current Ratio: Compares current assets to current liabilities, indicating the company’s ability to cover short-term obligations. The higher the ratio, the better!

• Working Capital: Current assets less current liabilities. This indicates the business’s available funds to finance day-to-day operations.

• Operating Cash Flow: Evaluates the cash generated from the company’s core business operations. Positive operating cash flow indicates the company can both sustain and grow its day-to-day operations.

Leverage Ratios: how much debt is there is in the business? How much financial flexibility is there?

• Debt-to-Equity Ratio: Measures the proportion of debt financing relative to equity. High debt levels can indicate financial risk, while low levels may suggest stability but could also mean missed growth opportunities. This is often a condition of any bank loan borrowing.

• Interest Coverage Ratio: Indicates the company’s ability to cover interest expenses with operating income. A higher ratio indicates a better capacity to meet debt obligations as they fall due.

Growth Indicators: how quickly is the business growing?

• Earnings Per Share (EPS) Growth: Reflects the growth in earnings available to shareholders over time. Positive EPS growth suggests improving profitability.

Market Valuation: how much is the business worth?

• Price-to-Earnings (P/E) Ratio: Indicates the company’s valuation relative to its earnings. A lower ratio may suggest undervaluation, while a higher ratio could indicate strong performance but also overvaluation. This is often used as a relative value comparison tool.

What about EBITDA?

Definition – EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) is a widely used financial metric that applies to both public and private companies, including family-owned businesses. EBITDA is a measure of the business’s ability to generate income, often used as a proxy for operating cash flow and is particularly relevant in the context of assessing a company’s profitability and financial performance.

EBITDA can be valuable when evaluating the operational efficiency and profitability of a business because it focuses solely on the core operating performance, excluding the effects of different financing decisions, accounting methods, and tax environments.

Here’s how EBITDA can be relevant when considering taking over a family business:

• Profitability Assessment: EBITDA provides a clear picture of a company’s ability to generate profits from its core operations before considering the impact of interest, taxes, depreciation, and amortisation. This metric allows for a more straightforward comparison of profitability against direct competitors.

• Cash Flow Measurement: EBITDA represents cash flow generated by ongoing operations, and so is useful for assessing a company’s ability to generate cash to cover operating expenses, capital expenditures, and debt obligations.

• Valuation: EBITDA is often used as a basis for valuation multiples in mergers and acquisitions. It can help potential buyers or investors determine the company’s worth by applying a multiple to its EBITDA.

• Financial Health: EBITDA can indicate the financial health and stability of a company, as higher EBITDA margins suggest stronger operational efficiency and profitability, particularly if there is growth year-on-year.

While EBITDA can be a useful metric, it also has its limitations. EBITDA does not reflect capital expenditures necessary to maintain or grow the business, nor does it permit consideration of changes in working capital requirements. Therefore, it’s important that EBITDA is considered along with those other financial indicators held to be key for that particular family business.

Spending time with the business’ accountants and other trusted advisers as well as conducting thorough due diligence, where necessary, are also essential steps in the decision-making process.

Lastly, it is imperative to note that assessing financial indicators alongside identifying qualitative factors such as industry trends, competitive landscape, potential strengths/weaknesses, and the company’s strategic objectives will provide a more comprehensive understanding how the family business is performing and will better inform all decisions.