With rising interest rates and pressure on profit margins, we sometimes have to evaluate a company and advise the shareholder that it is worth the value of the assets. The reaction of the entrepreneur can be discouragement as they believe that something more was built in their lifetime.
Let’s see the whole process from the beginning. Once the EBITDA (earnings before interest, taxes, and amortization) is properly assessed, this gives us an idea of the financial capacity of the company. It is the cash generated by the company to pay its debts and provide a return.
If a company generates $500,000 in EBITDA and if to operate it needs $2,000,000 in equipment and $500,000 in working capital, then it is very likely that it will not have goodwill. Here’s why: to back $2,500,000 in assets, we’re talking $175,000 in interest (using 7%). Then you must pay the debt (normally over 5 years), which would mean $500,000 per year. There is therefore a lack of cash generated to pay the commitments of such an acquisition, not to mention that some equipment will most likely have to be replaced during this period. This then results as a transaction without goodwill.
To justify goodwill in a transaction, the EBITDA generated must exceed the financial needs to pay for the assets involved in the operations.
To improve results and balance, one can look at excess assets – what can be sold that is less useful in the normal course of business. Long time owners/operators are very adept at keeping inventory and equipment that is not in use.
Conversely, a software company that generates $1,500,000 in EBITDA with few assets will be highly valued in goodwill.
We see traffic across multiple industries, company sizes, and business models. It’s all about profitability and revenue predictability. A professional will be able to help you understand if your business has the potential to have goodwill.