Cash Flows Versus Profitability
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Every business owner knows that cash is king. For a business to be successful, it must have good cash flow. However, for a business to be valuable, it must also be predictably profitable. And as we’ll see, these are not always the same thing.
As an example, I recently worked with a business owner, who we’ll call John. John’s business was very profitable, and revenues were growing rapidly. However, his business required large amounts of working capital, and there was a significant lag to their collections process. In fact, they couldn’t even bill until projects, which were highly capital intensive, were complete. So as the business grew, he needed an increasing amount of capital to keep projects going; and often it was months before they were paid for work. The faster the company grew, the bigger the problem was. Clearly, this is an example of a company with significant cash flow concerns that must be addressed if the company is to be successful long-term.
In another example, I met a business owner several years ago, who we’ll call Jane. Jane owned a food service business and cash collections were immediate. In fact, a high percentage of collections were in cash, and that’s where Jane’s problem began. Years earlier, she received poor advice that she should not implement a strong accounting system, including internal controls. She was told it would allow the business to pocket much of the cash “under the table” and not pay taxes on these revenues. The result was a business with strong cash flows, but one that also reported a loss every year. Jane had no idea what her costs or margins were or even how much money employees may be stealing from her. This is an unfortunate example of a business that is unsellable.
The lessons from these stories are simple; strong cash flows make a business successful, and profits make a business valuable. As such, being able to manage cash flows and accurately predict and measure profits is critical for a business owner planning their exit.
A good place to gain understanding of how to analyze cash flow and profitability, is to review industry level information. This information can be obtained from valuation specialists, trade or industry associations, or even good, old-fashioned research. In many cases, bankers can also provide helpful industry specific data. Once a business owner has a good understanding of industry level expectations, the next step is to compare these metrics to their company’s financial statements and projections: specifically, their balance sheet and income statement.
The balance sheet is a good place to understand how well a company manages cash flow, and more specifically, if there is enough working capital for the company to operate successfully. “Working Capital” is simply a company’s current assets minus current liabilities. The goal is to have sufficient assets to pay bills as they come due. Industry norms are also important to consider. In some industries, receivables are collected more quickly than payables are paid. This can lead to a lower need for working capital. If this is normal for the industry, maintaining lower working capital isn’t an issue. Seasonality may also be a concern for some businesses. If there are predictable periods of the year with lower cash flows, a higher degree of working capital will be required. In every case, buyers will test these assumptions during the due diligence process. Business owners need to be ready to defend their treatment of working capital.
Other metrics that measure working capital are the current and quick ratios. The current ratio is calculated as current assets divided by current liabilities, while the quick ratio is current assets (but without inventory and prepaid expenses) divided by current liabilities. The quick ratio is a more stringent test of liquidity, but in either case, a ratio over one is preferable. This indicates the business has enough liquidity available to cover current debt obligations. These ratios are even more important if a business experiences significant seasonality.
Finally, while maintaining enough working capital in the business is important, it’s equally important to not hold too much working capital in the business. For example, in working with a construction company several years ago, we discovered the owner was in the habit of leaving excess cash in the business “just in case” he ever needed it. The result was that he had amassed several million dollars of excess cash in the company; far more than was required by any bank or bonding requirement. While there are several reasons this is problematic, two are obvious. The first is liability. Excess cash on the books of the company is much easier for a potential creditor to seize in the event of a lawsuit. Secondly, having too much working capital on the books of the company may lead a prospective buyer to assume the additional liquidity is necessary. This would create problems if the seller subsequently desires to remove this cash shortly before a transaction. In either case, the cost could be substantial to the owner.
Turnover and Debt
Other items on the Balance Sheet that are important to understand and manage are turnover and debt. Some turnover ratios to understand and manage are:
- Receivables Turnover (Net Credit Sales / Average Accounts Receivable) – Measures how fast credit sales are collected.
- Inventory Turnover (Cost of Goods Sold / Average Inventory) – Measures how fast inventory moves through a business. A low inventory turnover likely means increased costs associated with obtaining and holding inventory that is not quickly converted to cash flow.
- Payables Turnover (Credit Purchases / Average Payables) – Measures how fast current purchases are paid for.
- If payables are paid slowly but receivables are collected quickly, working capital needs tend to be lower. However, be aware of any financing costs this may unnecessarily create.
- If receivables are collected more slowly than payables are paid, this tends to give rise to needing more working capital in the business.
Most business owners intuitively know how much capital they will need in the business for the next 6-12 months to cover normal operations. The point of these metrics is to begin documenting and tracking these amounts and to understand how this compares to the industry. In doing so, it will be much easier to defend working capital throughout, and even after, the sales process.
The last item to consider on a business’s balance sheet is capitalization. Capitalization is the measure of how much debt versus equity is being used to support a company’s asset base. Similar to other metrics previously discussed, it is important to understand a company’s capitalization and also compare it with how other companies in the same industry operate.
If a company’s capitalization incorporates a significant amount of debt, here are some items to consider:
- Long-Term or Short-Term Debt – How often does company debt mature or come due? Could that put a strain on cash flows?
- Seasonal Debt – Does the company have a line of credit it draws from every year that might indicate a lack of liquidity in the business to cover operations?
- Balloon Payments – Are there any debts with a balloon payment that could be triggered in certain events?
- Personal Guarantees – Does the owner have any personal guarantees that need to be transitioned to someone else in the event of an ownership change? If so, what would need to happen to start doing that now?
- Payoff – In the majority of sales, debt does not follow the transaction and must be paid off or otherwise taken out of the proceeds at the closing table. When that happens, will there be sufficient proceeds remaining to have a successful transaction?
Other industries may choose to utilize owner financing for company capitalization. Whatever the case may be, it’s a good idea for owners to consider the capitalization of their company from the perspective of a potential buyer.
The purpose of a company’s income statement is to measure its profitability. During the due diligence process, a buyer will review the seller’s income statement to measure profitability, while also testing the consistency and reliability of the reported profits. To substantiate revenues, a savvy seller will implement strong internal controls to reduce the risk of future cash flows to a buyer. Remember Jane, the business owner who had no internal controls to monitor revenues and cash flow? A lack of controls creates a business that is unsellable. To maximize company value, owners need to substantiate revenues and control and minimize expenses. For most owners, a great first step in defending their company’s value is having audited, or at least reviewed, financial statements. By having this procedure in place before entering the sales process, it will add substantial strength to a seller’s negotiations.
Another control that is often overlooked is implementing a process for tracking an annual budget and forecasting future financial returns. An owner anticipating a transaction should begin an annual budgetary process and should also begin forecasting the business operations for the next three to five years. In doing so, it provides performance accountability while painting the picture of future growth for a prospective buyer.
Revenues are a buyer’s top priority as they examine a company’s profitability. Buyers will focus on whether revenues are growing and what future projections are based on. Are revenues recurring or more transactional in nature? Does the company have contracts with customers, and what is the annual customer retention rate? Consider the revenue pattern for most reputable CPA firms. CPA firms rarely have contracts, but this is a highly relational business. As such, client retention tends to be very high year after year. Being able to articulate this, even in the absence of contracts, is incredibly valuable to a buyer. Buyers will also want to understand what up-front, sunk costs buyers may have, and how easy it is for customers to change suppliers. How many customers does a company have, and does a high proportion of revenues come from a small percentage of the customer base? What is the likelihood that one or more major customers will leave? How liberal are the company’s credit policies, and does it have the ability to implement more stringent policies? And finally, what type of price pressure is there in the industry, and do they have the ability to raise prices? A buyer will consider all these aspects during due diligence. Being ready to substantiate and defend revenue projections is critical to preserving a company’s valuation throughout the sales process.
Cost of Sales
It’s important for business owners to have a process for reviewing and controlling costs at least annually. Are there any significant concentrations of suppliers, such that if one were lost, they would be difficult to replace? If so, how can this be mitigated? Are there any long-term contracts that mitigate the risk of rising costs? What financing and payment terms are available from suppliers? As with the turnover metrics previously discussed, can payments to suppliers be deferred until after customer collections have been received? Finally, what is the company’s gross profit margin, and how does it compare to others in the industry? Is this margin rising or shrinking, and what is it projected to do in the future?
Operating expenses are a good example of an area where a disciplined CFO can prove invaluable. All too often, business owners focus more on top line revenues or even gross margins and forget to keep operating costs in check. It’s no surprise that these are often the first costs to get neglected when a company isn’t properly managing its financial statements. Many owners run personal expenses through business operations. While there can be some obvious income tax advantages of doing so, it can unnecessarily lower company profits which can then lower company value. Operating costs should be monitored closely each year for any abnormal trends. This can provide an early warning sign of increasing costs, or in some cases, even fraud.
During pre-sale due diligence, buyers will critically examine a company’s cash flows and profitability before arriving at the closing table. A savvy seller will take the time to analyze these aspects of their company long before entering the sales process. By implementing appropriate processes and internal controls, a business owner can substantiate their margins and dramatically increase the quality of their earnings. Combining these items increases profits while reducing cash flow risk for a prospective buyer. The company that does this successfully will have a very strong case for being able to demand a premium price, and defend that price throughout the sales process.
Who Is Brightworth?
Brightworth is a nationally recognized, fee-only wealth management firm with offices in Atlanta, GA and Charlotte, NC. The wealth advisors at Brightworth have deep expertise across the financial disciplines, allowing us to provide ongoing, comprehensive financial advice to families across the country.
This information is provided as a guide to assist you in your financial planning. The examples are provided for illustrative purposes only and are not intended to be specific financial planning recommendations or tax advice. Please consult with a professional for specific questions regarding your particular situation.