How much do you know about the North American Industry Classification System (NAICS)? If you’re like a lot of business owners, chances are, not much.
Here is a short overview of the system and how to navigate it:

What is NAICS?

The North American Classification System was introduced to essentially replace the older method, Standard Industrial Classification (SIC). Developed in the 1930’s, SIC was the go-to method of industry classification. However, it has recently been overshadowed by NAICS because of frequent criticism that the SIC process has proved unable to handle the rapid current economic change.
NAICS assigns a code to a business to correspond with their economic activity. This system breaks down into twenty industry sectors. For small businesses, these codes are typically used for contracting and tax purposes.
As the SBA states on its website, a NAICS code is comprised of six digits. The first two indicating your economic sector, the third your industry subsector, the fourth corresponding to your industry group, the fifth referring to your industry and the sixth denotes if an establishment is specific to the US, Canada or Mexico.

Why is it Relevant to You?

Potential applications of the NAICS knowledge include:

• Statistical analysis
• Risk assessment for insurance
• Tax incentives
• B2B
• Benchmarking
The NAICS is can play a substantial role in the life of a small business. One application of these codes is by the government to generate statistics for analysis to aid research. When applying for business insurance, an agency will likely use your NAICS code when assessing risk and generating rates. High-risk industries require different action. In addition, some federal and state agencies require an establishment to have a NAICS code for tax reasons and occasionally tax breaks are given to businesses in specific industries. If you work with a company that has B2B (business to business) arrangement with other companies, you can use the NAICS code to glean important information about prospective customers. In short, it is a system of industry categorization that could be used for a wide range of analytical purposes. Take benchmarking for instance; as a business owner, you may be interested in determining how your financial statements compare with that of your peers. It is important to at least have a marginal understanding of the NAICS code system before setting out on your benchmarking quest.

How can you place your company within NAICS?

For instance, you run a software publishing firm and need to determine your NAICS code. Publishing is within the “Information” economic sector, thus NAICS 51. This economic sector includes Publishing Industries (NAICS 511), but also includes Motion Picture and Sound Recording Industries (NAICS 512), Broadcasting (NAICS 515), Telecommunications (NAICS 51), Internet Service Providers (NAICS 518), and more. If benchmarking and looking for financial data and trends from firms in our example industry, we need to refine our NAICS code to the six-digit level. Let us follow the three-digit Industry Subsector of NAICS 511 for Publishing Industries.
Within Publishing Industries, the four-digit Industry Group reveals two industries: Newspaper, Periodical, Book, and Directory Publishers (NAICS 5111), and Software Publishers (NAICS 5112). This particular industry does not break down into any further segments so the five-digit Industry code takes on a single “one” showing NAICS 51121. Likewise, if there were several types of Software Publishers within the NAICS code system, they would correspond with a fifth digit as 1, 2, 3, and so on. Lastly, the six-digit U.S. National Industry code for our sample industry is NAICS 511210 Software Publishers, as no further breakdowns exist.

Learn more

A wonderful source for searching NAICS codes and learning their structure and descriptions is the U.S. Census Bureau’s NAICS website at http://www.census.gov/eos/www/naics/. In addition, FINTEL offers its own resource for researching the NAICS system linked with its Industry Metrics tool. Happy searching!

Just when the economic outlook seems very bleak to us in the US, as well as abroad of course, there is some hope for selling a company. Obviously, it’s extremely tough to sell a business and it is not for the feint of heart. Buyers want positive cash flows, profit growth etc etc etc. You have heard it a million times. But fortunately there seems to be a light at the end of the tunnel. Investors overseas, particularly in the massive force that is China, are dying for ways to get an “in” into the American market without paying the high price tag.

So you want to know the approximate worth of your interest in a business. You want to pin down the exact economic value you have spent innumerable hours perfecting. How do you even begin to get a clue about this? If you are looking to sell, would you have the remotest idea about a legitimate selling price? Lets go over some of the most basic concepts of business valuation to give you an idea.

Defining your Motives and Describing Your Environment

First and foremost you must define why you are constructing a business valuation. What are the reasons for and circumstances surrounding your decision to conduct this analysis?
Next, you need to describe the conditions of the economic world surrounding the deal. It’s important to research the vitality of your industry currently as well as the more basic local and regional economic conditions.

Comparable Transactions

Another good initial step toward putting a value on your enterprise is looking to your peers. Find a similarly structured transaction to your proposed financing deal structure. This means finding a company with the following criteria:
• Comparable in size of
o Market
o Number of employees
o Product type
o Industry
• Similar life stage
• Geographic proximity
Looking at a business that somewhat mirrors yours is a good way to project some things for yourself. It is also good to investigate how the deals went for both parties and what percent ownership investors acquired in proxy transactions.

Valuation Techniques

Book Value

This is the simplest way to define what you are worth. The numbers. The book value is, simply put, the value an asset carries on a balance sheet. This is calculated for a company by subtracting intangible assets and liabilities from total assets. The book value is helpful in one of the most basic ways- it is a tangible starting point for evaluation. It gives you something to base other analyses off of. Of course it is important to note that accounting practices have a significant effect on book value and should be taken into consideration.

Adjusted Book Value

The adjusted book value is designed to reflect fair market value. This is done by considering the book value but also subtracting off balance sheet liabilities. The ABV is able to adjust for large discrepancies between the book and actual market value of tangible assets. It also adjusts intangible assets to zero, which is an often criticized part of the method. This can be a good way to showcase the equity of a company but is not often accepted as a trustworthy valuation technique.

Liquidation Value

This particular practice is not usually of any importance to a buyer or seller but it can be constructive as a “floor value.” This estimates the value that could be made from a quick sale but is merely an indication rather than a concrete estimate to base decisions off of.

Market Multiples

A market multiples analysis, also referred to as a comparison analysis, uses comparable businesses in your industry to assess value. It uses averages to produce more broad-range, but accurate results. One of the most praised parts of the market multiples approach is its ease of use. There is no need to compute discounted cash flows and it is a relatively easy to understand. Components/ ratios of this approach are:
• Price to Earnings Multiple
• Price to Sales Multiple
• Price to Invested Capital
• Price to Book Value

Net Present Value/Discounted Cash Flows

This is difference between the present value of cash inflows and cash outflows. It is a cash flow summary designed to reflect the time value of money. A company’s cash flows are discounted back to the present value using a market-adjusted discount rate.

Art and a Science

There is no doubt that valuations are much more complex than the basic methods outlined here, and this list is not exhaustive. However, these methods do fall into one of the traditional categories of valuation: assessment of business assets & liabilities (Asset Approach), historical earnings, future earnings (Income Approach), and industry or market-specific trends and multiples (Market Approach). In reality, a combination of several methods is generally applied for a more comprehensive approach to business valuations.

How does one determine the appropriate combination? For values achieved by each complementary method, how is a weighted average applied to arrive at an appropriate value? Defining your motives and describing your geographic, economic and competitive environment all play a role in this complex decision. It is this facet of valuation that leads many Business Appraisers to refer to their trade as more of an art than a science.

Solutions

Considering the complexity involved in any serious business valuation, we suggest hiring an experienced Business Appraiser. However, to get a “ball-park” perspective on what your firm may be worth, there are plenty of tools on the market. Business Owners may consider several of the Financial Calculators available online, like those available at http://www.dinkytown.net for instance.
For Business Coaches with a need to analyze existing and pro-forma statements for clients, the FINTEL Business Analyzer provides a great solution to quick and powerful business valuations, using methods including Book Value, Earnings Capitalized, Capitalization of Current Earnings, Average and Top Quartile P/E Ratios, and Operating Income Multiple showing values for each method with a weighted average considering all methods for a more comprehensive approach.

Food for Thought

Whether business owner, business coach, or prospective entrepreneur - it pays to learn more about this very complex topic of business valuation. Why, you ask? Why not just leave the valuations to the experienced Business Appraiser as suggested? Consider, the financial and operational decisions that have been made, currently applied, and prospectively planned within a company all impact its current and future value. Thus, a more complete understanding of valuation allows decision-makers to maximize value-enhancing strategies and minimize value-reducing mishaps with this perspective in mind.

Has your business been profiting consistently? Ah! You have been booking profits on your Profit and Loss statements annually for the last few years. Is that enough to say you are profitable? Think again.

To have a comprehensive understanding of the values of your business from every conceivable perspective would make you financially intelligent. Only then would you be able to determine if your business has been profiting in the true sense of the word - ‘business’. That would imperatively mean a theoretical and practical knowledge of your business. So, what is profitability analysis?

Earlier, the concept of ‘profit’ began and ended at the point wherein you had recovered your initial input costs. Then, it moved on to take into account the depreciation of assets. Today, you may analyze your finances from the perspective of various business activities, i.e., the cost of placing an order or a group of products, servicing a customer or a group of customers, etc. Hence, profitability analysis may be studied at different levels – marketing level, order level, customer level, channel level, enterprise level, to name a few. You will then be able to decide where to increase or decrease capital infusion to generate more profits. Alternatively, profitability analysis may be studied as various segments for each product or service, or, group of products/services, as the case may be. You also have the concept of Profit Centers, whereby each unit is expected to generate its own profits and thereby, add value to the organization. You may even work out the profitability per employee. Profitability Analysis today, has taken on a whole new meaning in a much larger context of the business.

Broadly, as an equation,

Profitability Index = Present value of future cash flow/ Cost of Investments

A profitability index reflects the relationship between cost and benefit for a particular aspect of your business entity. This can be calculated by using profitability ratios as a tool. There are many Financial Ratios that can be applied as tools to measure different aspects of your business. It helps you identify the Gross Profit Margin, Net Profit Margin, Operating Margin, the Internal Rate of Return, Return on Capital Employed, Return on Fixed Assets, Return on Total Assets, Return on Sales, to name only a few. The results yielded by these calculations give you information, insights and perspectives crucial to your business. Aside from researching company’s own performance trends illustrated by these indicators, it’s extremely important to place them in the relevant industry context by comparing their levels with those of competitors and industry peers. Management of these results helps you streamline your business operations: ultimately, to maximize profits with optimum utilization of all your resources.

Thereby, a profitability analysis helps you make investment decisions, guides you to plan your cash flows, to plan your profit margins and to take a host of other business decisions. Meanwhile, do not forget to compute your tax returns!

You may be managing your own business or you may be helping others manage their businesses. FINTEL can help you work with such relevant numbers and data as well as guide you with benchmarking figures for your specific industry.

All said and done, Profitability is, and will remain, the primary objective of any business.

Accounting and financial management have often been regarded as the most complex aspects of managing a business. The numbers are usually big, the formulae confusing and there are so many regulations. It is fine for the Director of Finance/CFO and his/her team but what about the other stakeholders, especially average investors and the managers actually running the show. How can they ensure that their investment is safe or their performance is in line with organizational goals?

Financial ratios provide a quick and comparable view of the performance of a business - by using financial ratio analysis, a lot of seemingly complex and overwhelming accounting information and year-end reporting can be made easy to comprehend. It may not be easy to adjudge the performance of a company over a period of time, say over five years or compare the same with a competitor or industry peer by looking at the year-end reporting, at least for an average investor. However, the use of financial performance ratios makes this possible. Financial analysts at business channels and newspapers use these to recommend one stock over the other. Stakeholders and the Board keep a close watch on these in order to ensure that the management is doing its job properly.

Use and Limitations of Financial Ratio Analysis

However, one must keep in mind the following issues when using financial ratios:

- One of the most important reasons for using financial ratio analysis is comparability and for this, a reference point is required. Usually, financial ratios are compared to historical ratios of the business itself, competitor’s financial ratios or the overall ratios of the industry in question. Performance may be adjudged as against organizational goals or forecasts.

- A number of ratios must be analysed together to get a true and reliable picture of the financial performance of the business. Relying on each ratio individually may not be a good strategy.

- Year-end values may not be truly representative of the actual performance of the business and hence, average values should be used when they are available.

- The limitations of accounting methods also apply to financial ratio analysis. The selection and application of accounting standards may result in different ratio values.

Financial ratio analysis, in fact, has a great use in management accounting which differs from financial accounting in being an on-going, performance management exercise.

How much debt a business has on its balance sheet? This is an important consideration when it comes to assessing financial health of a firm. Leverage ratios disclose to what an extent debt is used in a firm’s capital structure. It is believed that the more debt a firm has in its capital structure, the riskier its stock becomes. The underlying reason for this is that debtors have a priority or first claim to a firm’s assets and if ever, the firm went bankrupt, debtor’s claims must be paid off before stockholders (who are party to business risk and owners of the firm).

Debt/Equity Ratio

D/E or debt/equity ratio is an indicator of the debt financing in a business as compared to stockholder equity (finance by its owners/shareholders).

The formula for Debt/Equity Ratio

Debt/Equity Ratio = (Short-Term Debt + Long-Term Debt) / Total Equity

A high debt/equity ratio is an indicator of high risk business and a low debt/equity ratio, if other factors are similar, is deemed to mean that the business is less riskier than those with higher debt/equity ratio. However, one should not jump to the conclusion that debt is an evil and a low debt/equity ratio is an indicator of splendid financial management. Low debt/equity ratio may also indicate that a business is not using financial leverage to enhance its profitability.

How? One is prompted to ask….

Very briefly, the cost of debt is ‘fixed’ while that of equity is not – shareholders have a claim on the profits through dividends. It is also important to note that ‘fixed’ doesn’t necessarily mean high cost and that is where financial leverage comes into play – by optimizing its capital structure on debt as well as equity, a business actually ends up paying out less as a composite of dividends and interest.

Another factor that is to be remembered is that comparison of debt/equity ratios should generally be done among businesses within the same industry as higher debt/equity ratios are generally observed in capital-intensive industries.

We’ll learn about Interest Coverage in the next post.

It is imperative for a business owner to be ‘on top of things’ and constantly evaluate the performance of the business, irrespective of the size of the business – it could be a small printing business or a mammoth multi-product conglomerate. Business performance, though it may seem great in absolute terms, always has subjectivity involved and it is crucial to compare it industry competitors & established industry benchmarks. It is here that financial ratio analysis comes in handy.
The purpose of this post is to introduce the subject of financial analysis to small businesses, entrepreneurs and young managers, especially the significance of financial ratios.

What is financial ratio analysis?

Financial ratio analysis is the selection, evaluation and interpretation of financial data in easier to understand ratios, which have been identified as critical indicators of financial performance of the business and can be used for strategy and decision-making. Financial ratio analysis is popularly used to compare a firm’s financial performance over a period of time (trend analysis) or to assess performance in comparison to other businesses.

Categories of financial ratios

Financial ratios can be grouped into categories which highlight the various facets of a firm’s financial health and operational efficiency. Some of the categories of ratios are given below:

• Leverage Ratios disclose to what extent debt is used in a firm’s capital structure.
• Liquidity Ratios present a firm’s short term financial situation or solvency.
• Operational Ratios present a firm’s operational efficiency & asset utilization.
• Profitability Ratios indicate the return on sales and capital employed.
• Solvency Ratios measure a firm’s ability to generate cash flow and honor its financial obligations.

In our next post, we’ll take up Leverage Ratios in more detail.