Building the Value of Your Company

Building The Value of Your Company

Steve Brandt, President

HydraMaster Corporation

Mukilteo, Washington

February 2004

There are only two circumstances I can think of where you would want to build the value of your company… one would be if you plan to sell your business. The other would be if you plan to keep your business.

The very things that are valuable to you as the owner of your business are the same things that are valuable and attractive to a potential buyer of your business. For that reason, you don’t have to be planning to sell your company before you think about shaping and organizing it to produce the maximum value.

What to Focus on…

I. Cash - How much you have, how much you need and where to get it.

II. Asset Management – You won’t have enough Cash without it, Can’t borrow from a bank without mastering it.

III. Profit – Gross Profit & Net Profit Before Tax

IV. EBITDA – Earnings Before Interest, Taxes, Depreciation, Amortization.

V. “Lifestyle” & Discretionary Expenses – Add Backs to Profit, hidden value.

Cash Is King

You pay taxes on your profits but you live or die with cash.

1. There is a BIG difference between cash and profit.

2. Growing Sales requires that you generate cash to support that growth

· larger average inventory

· more receivables outstanding

3. You can grow yourself into bankruptcy.

4. Lots of strategies to produce cash…

· Increase Sales

· Raise prices

· Borrow on your assets

· Borrow on your receivables

· Collect your accounts receivable faster

· Charge late fees or finance charges

· Offer early-payment discounts

· Accept credit cards

· Invoice faster and more frequently

· Lease to avoid down payments

· Reduce Inventory –liquidate poor selling items

· Turn Inventory faster

· Negotiate extended payment terms

· Sell unneeded equipment, assets

· Reduce overhead expenses

· Increase employee productivity

· Convert short-term debt to long-term debt

· Take on an equity partner

Managing Your Assets

1. Asset Management Ratios that measure your liquidity (cash):

Current Ratio = Current Assets

Current Liabilities

Quick (Acid) Ratio = Cash + Accounts Receivable

Current Liabilities

2. Ratios that track how well you are paying your bills:

Accounts Payable Turns = Cost of Goods Sold

Accounts Payable

Accounts Payable Days = 365

Accounts Payable Turns

2. Ratios that measure the efficiency of your two biggest assets; Accounts Receivable and Inventory:

Accounts Receivable Turns = Sales

A/R

Accounts Receivable Days = 365

A/R Turns

Inventory Turns = Cost of Goods Sold

Inventory

Inventory Turn Days = 365

Inventory Turns

Your company does not make any money or produce any cash flow with inventory sitting on a shelf.

Strategies to improve inventory turns…

· Reduce overstocking

· Increase order frequency

· Quit buying more than you need just to save freight

· Liquidate and discontinue slow movers

It’s all about balance…improving inventory turnover while not creating a shortage resulting in lost sales.

Profit

To better manage profit, divide the Income Statement up into two parts; Gross Profit and Net Profit.

Gross Profit & Margin – This number is the amount of money left over from Sales after the vendors are paid, and it must cover your general operating expenses (overhead) and hopefully have some profit left over. The Margin is expressed as a percentage relationship between your Sales and the Gross Profit.

Measuring Gross Profit and Gross Margin

Gross Profit = Sales – Cost of Goods Sold

Gross Margin % = Gross Profit

Sales

The Gross Profit produced by your company must produce enough dollars to service your overhead expenses and still leave a profit. If it doesn’t then something has to change

Strategies that will improve the volume of Gross Profit dollars available…

· Increase Sales

· Increase Gross Margin

Strategies that will improve your Gross Margin…

· Raise prices

· Change the sales mix to favor higher profit products/services

· Reduce discounts

· Reduce cost of goods through better buying

· Reduce direct labor costs through productivity/efficiency

· Reduce shrinkage

It’s all about balance… getting enough margin without chasing away all the sales.

Net Profit & Margin – The bottom line. You have to have one to stay in business. Want to add value to your company? Increase this number!

Measuring Net Profit and Net Profit Margin

Net Profit = Sales – Cost of Goods Sold – Operating/Overhead Expenses

Net Margin % = Net Profit

Sales

What’s a good Net Profit?

It can depend on how fast you are growing

10% + would be wonderful

Over 5% would be solid

Under 5% is dangerous territory

How to improve Net Profit?

· Gross Profit Improvement Strategies

· Control Operating Expenses better

· Increase Sales

· Manage Assets more efficiently

EBITDA

Earnings Before Interest, Taxes, Depreciation, Amortization

The concept of EBITDA is a different way of looking at the cash profitability a business spins off. It is the amount the business produces that can be used to service debt payments.

This method of evaluating income is most valuable to someone who may consider acquiring your company. It gives them a sense of how much money a company is generating before it shells it all out to creditors, Uncle Sam, etc.

If EBITDA grows over time, it gives investors some sense of future profitability, adding value to your company and adding to the price you can command for it.

“Lifestyle” & Discretionary Expenses

One of the great and immediate values of a small business to its owner are the “perks” that the business can provide for the owner. For instance, it may not be absolutely essential that the owner drives around in an expensive new SUV, maintains season tickets with the local NBA franchise to entertain “clients” and pays a fat rent payment to the owner for the fancy building it is in. But wait, don’t bury these non-essential expenses too deeply, they may prove valuable.

Two reasons to track these expenses…

1. They can be added-back to net profit for purposes of evaluating exactly what bottom line the business is really providing to the owner.

2. If you ever anticipate selling your business, these add-backs are legitimately put back into profit for purposes of the acquirer’s evaluation of the business’ true arms length profitability.

Some examples of Non-Essential business expenses…

· Vehicles not essential to business purposes

· Many types of entertainment expenses

· Excessive compensation paid to owner’s and relatives

· Excess retirement provisions for owner’s

· Rent costs beyond essential needs

· Resort business travel for owner and family (cruises)

Note: You can successfully argue to the IRS that these expenses are beneficial to the company but if they aren’t a great bargain for what they produce then a portion may be considered non-essential.

Selling a Lifestyle: For the owner of a small business, when it comes time to sell, you will likely be selling to an individual, not a large investment firm. To raise your company’s perceived value and command a higher price, show your profit but sell the lifestyle, complete with all the perks and benefits (many tax free) that the business has allowed you to enjoy.

Final thoughts on what adds value for you or for a buyer…

· A deep management team

· Diversity in your customer base (not a few large customers) – spreading the risk

· Diversity in you product/service offering – spreading the risk

· Vendor diversity – no over reliance on a single vendor

· Good cash flow

· Good asset management

· A business the maximizes profits over sales