7 Financial Metrics for Planning Your Exit Strategy, Part 1

Few things shape the outcome of a business exit more than the state of your finances. A well-documented financial history signals stability and value to buyers, while gaps or inconsistencies can cast doubt and make the sale feel like a gamble.

Simply put, the clearer your financials, the smoother the path to the final sale.?

As we continue our series on Updating Your Business Exit Strategy, we’ll show you where to focus your efforts as you start the process of completing a pre-exit financial health check.

Cash Flow

Cash flow measures how money flows in and out of your business: what’s earned versus what’s spent. Buyers will be interested in knowing two primary types: operational cash flow, which measures the cash generated by day-to-day activities, and free cash flow, which shows what’s left after major expenses like equipment purchases or debt repayments.?

Why Operational Cash Flow Matters to Buyers

From a buyer’s perspective, stable, predictable cash flow means there’s less likely to be an unpleasant financial surprise post-acquisition. Rather, they get the reassurance that your business has the necessary liquidity to sustain operations for the foreseeable future.?

Operational Cash Flow Formula

Operational Cash Flow = Net Income + Non-Cash Expenses – Change in Working Capital

• Net Income: Income after taking out taxes, expenses, and COGS (cost of goods sold)
• Non-Cash Expenses: Depreciation, amortization, deferred tax, etc.?
• Change in Working Capital: The difference between current assets, like accounts receivable, and current liabilities, like accounts payable, over a particular period.?

Let’s say your business has:

• Net income of $200,000.
• Depreciation expense of $20,000.
• A $10,000 increase in accounts receivable.
• A $5,000 decrease in accounts payable.

Operational Cash Flow = 200,000 + 20,000 ? (10,000 + 5,000) = $205,000

Why Free Cash Flow Matters to Buyers

Taking the analysis a step further, free cash flow shows how much liquidity is available for long-term goals– paying down debt, funding growth initiatives, etc. A buyer won’t look too kindly on a history of unchecked negative free cash flow because it’s a signal that there’s either overinvestment or cash flow mismanagement.?

Free Cash Flow Formula

Free Cash Flow = Operational Cash Flow ? Capital Expenditure

• Capital Expenditure: Funds spent on long-term assets, like equipment or property.

Building on the previous operational cash flow example:

• Operational cash flow of $205,000
• Capital expenditures of $50,000

Free Cash Flow = 205,000 ? 50,000 = $155,000

Net Profit Margins

Next, you’ll want to demonstrate to your buyers how effectively your business converts revenue into actual profit. Net profit margin, often referred to as “the bottom line,” represents the percentage of revenue that remains after covering all expenses, taxes, and costs. In simpler terms, it’s how much profit you keep from every dollar earned.

This metric is particularly sensitive to fluctuations caused by factors like material costs, pricing strategies, employee pay, and more. However, these variables also present opportunities for control. While you can’t always prevent a supplier from raising raw material prices and compressing your margins, you can address the issue by switching to a more cost-effective supplier.?

Why Net Profit Margins Matter to Buyers

A consistently wide net profit margin is proof that not only is your business earning revenue, but it’s doing so efficiently. Your business can maintain profitability even in the face of factors out of your control because you’ve built in the necessary adaptability to come out on top of market fluctuations and increased competition.?

Formula for Net Profit Margin

Net Profit Margin (%) = (Total Revenue ÷ Net Income) × 100

Your business reports:

• Net income of $150,000
• Total revenue of $500,000

Net Profit Margin (%) = (500,000 ÷ 150,000) × 100 = 30%

So, for every dollar earned, your business was able to retain $0.30 in profit. Potential buyers will compare your net profit margin to industry benchmarks to determine whether your profits are under- or over-performing.?

You can reference this list of industry benchmarks available through The Finance Weekly, last updated on December 24, 2024.?

Debt-to-Equity Ratio

One way that buyers evaluate the level of risk associated with purchasing a business is looking at whether it relies more on borrowed money or equity funds.?

Equity in this context is capital contributed by owners and investors plus any retained earnings, meaning the profits your business reinvested rather than distributed. If you’ve consistently reinvested your earnings, you’ll naturally have a stronger equity base to offset debt obligations.?

Why Debt-to-Equity Ratio Matters to Buyers

A lower D/E ratio tells buyers that your business isn’t overly dependent on debt and has a solid equity base to fall back on in the face of unexpected challenges.?

On the other hand, a high D/E ratio might raise concerns about whether the business could handle downturns or interest rate increases without running into trouble.?

Most buyers will look for a balance between just enough debt to fuel growth but not so much that it jeopardizes your long-term sustainability.?

Formula for Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Shareholder Equity ÷ Total Liabilities

Your business reports:

• Total liabilities: $400,000
• Shareholder Equity: $800,000

Debt-to-Equity Ratio = 800,000 ÷ 400,000 = 0.5

A result of 0.5 means that your business has $0.50 in debt for every dollar of equity, which, like net profit margin, buyers will compare to similar organizations in the same industry to evaluate its riskiness. In general, though, a ratio less than 2.0 is considered healthy.?

More Exit Strategy Financial Metrics to Come?

We’ve covered the first half of the financial metrics that buyers will look to when assessing the value of your business, but there’s more work to do! Next week, we’ll cover the last three metrics you’ll want to consider as you complete your pre-exit financial health check.

In the meantime, consider scheduling a consultation with Lori Moen of Catalyst Group, ECR. As a Certified Exit Planning Advisor, Lori has the expertise to help you get your finances in order and position your business for a profitable transition.?