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by Dale Gillmore
Just as you take the time to meet with your physician annually, it’s important to step back and assess the health of your business just as often.
Knowing your company’s vital signs -- the numbers and ratios bankers and investors would use to assess its health -- is the first step in making sure you spend your time and business resources wisely. More importantly, failing to recognize any shortcomings you’re facing can have disastrous consequences.
In our Explore Package, we get to know you, your business, and your ultimate goals. Utilizing our best thinking and innovative technologies, we provide insight into the health of your business and reveal opportunities for improvement and growth, so you can move forward with certainty. The package includes:
For the purposes of this blog, we’ll cover just a portion of that package.
Here are seven key financial metrics that can help you understand your business, how you’re faring against competitors, and what areas need attention:
• Pre-tax net profit margin
• Current ratio
• Quick ratio
• Accounts payable days
• Accounts receivable days
• Inventory days
• Debt to equity ratio
Pre-tax net profit margin
Probably the most important metric, this tells how much profit you get to keep from each dollar in sales. For private companies, it is usually expressed as net profit before taxes in a given financial period divided by sales.
This number can show you how effective you’re being with expenses and if you should decrease certain expenses so that they don’t eat up as much of the revenues. The average net profit margin for private companies is around 7%, but it can vary dramatically by company and by industry.
Current ratio and quick ratio
These two metrics give you an idea of your liquidity, or how well you can meet your near-term obligations, and they are most helpful analyzed together. If the business does not have decent liquidity, then one unexpected expense could severely impact it.
Current ratio basically shows whether the assets that you can convert into cash quickly (within a year) will cover what you must pay off soon (in less than a year), and it is expressed as current assets divided by current liabilities. A ratio of less than one means you could run short of cash within the next year unless you generate additional cash.
The quick ratio shows a shorter-term view; it divides cash plus accounts receivable by current liabilities. The average private company’s quick ratio is 2.15.
Accounts payable days and accounts receivable days
These ratios help show how you’re managing the company’s cash position so that at any point in time, you have enough to cover commitments.
Accounts payable days can indicate whether you’re paying your suppliers too quickly and losing out on money you could be investing instead of distributing immediately.
What’s a good accounts payable turnover ratio? In general, higher numbers are better, but it can vary by industry pretty dramatically.
Accounts receivable days, meanwhile, can alert you when you’re not receiving payments from customers quickly enough. (It is expressed as accounts receivable divided by sales multiplied by 365 days.) Generally, lower numbers are better for accounts receivable, because it means you’re getting cash quickly. But this, too, will vary dramatically by industry.
The inventory days ratio (inventory divided by cost of goods sold, multiplied by 365 days) measures the number of days it takes to move inventory, but it is very specific to the industry. For example, restaurants’ products have a short shelf life relative to a clothing store’s merchandise. Still, lower numbers are generally better, because you want to turn over as much inventory as possible in a year.
Debt to equity ratio
Debt-equity ratio is one of the ways to measure your business's financial health. Dividing total liabilities by the owners' equity shows how much of the company's assets are tied up in debt. The higher the ratio, the more indebted the firm. Some debt/equity ratios plugin only long-term debt rather than all debt.
It is possible to grow your company by borrowing money to fuel expansion, but too much debt poses a risk. If you're expanding, but your debt ratio is too high, that's a sign your growth is fueled primarily by debt rather than substance. That's a risky strategy because companies can't sustain debt-fueled growth indefinitely without significant growth in profits.
Because all of these metrics can vary by type of industry, it’s difficult to make sense of financial ratios unless you find quality benchmark data that gives insight into businesses of similar industry, revenue size, and geographical location.
While your CPA and other advisors might be able to provide you these raw numbers and ratios, understanding their context and obtaining a deeper financial analysis is critical to understanding what’s possible for your business and what you can do to improve it -- key elements that set the stage for future success.
Give us a call to get started.
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by Dale Gillmore
We talk a lot about succession planning and with good reason: Most business owners are woefully unprepared for it. Part of that unpreparedness comes from focusing only on the mechanics of the deal -- the valuations, the tax loopholes, etc. -- and not enough time on the preparedness of the succession team to lead the company into the future.
I recently discussed eventual transition plans with a client who owns a small but highly profitable manufacturing business. He started the company on his own, ran it for 40 years, and plans to retire in the next ten years. Several years ago, his son entered the business and has since flourished in the company. He’s moving up the ranks quickly.
My client wanted to brainstorm on topics like appropriate payout, valuation, timing, and tax implications -- all critical considerations but insufficient when planning a successful transition. I suggested with think first about something else.
More important than valuation and taxes, at least initially, is to focus on making sure the transition is successful in the long term. This involves making sure that whoever you are handing over the reins to will be in a position to take over and effectively run the company. It seems obvious, but I routinely see more time and energy spent on the mechanics of the transition than making sure the people who are going to run the company have the skills and confidence to actually do it well.
We need not look further than the current attraction to ESOPs to illustrate this point. ESOPs are great for short-term tax solutions, but they too often fail in the long-term because the employees who overtake the organization aren’t properly prepared to do so.
In a dream world, you’d sell a business and receive 100% of the profits. This is rare and is especially so in an ESOP or when selling to family or employees. Most often the ESOP will pay a smaller percentage in cash at closing and then will pay a seller note or earnout over time based on the success of the company. In that case, or in the case of transitioning to a younger family member, there may be very little cash received at the time of the sale. When this occurs, the majority of the purchase price is paid for over a period of time from the company’s profits. And this, of course, is why the long-term success of the company is so important. You can hire the best legal and tax team available to work on the mechanics of the transition, but if you don’t educate and empower the new owners, the company will flounder and all the expected transition proceeds will never materialize.
In other words, the biggest risk in transition planning via employees, ESOPs, or family succession isn’t improper valuations or missed tax loopholes. It is the future success of the company since all or most of the buyout occurs after the sale is completed. This is why it is critical to spend time, energy, money, and resources doing whatever it takes to ensure your succession team is confident, skilled, and ready to take over and grow the company after you depart.
If you own a business and are starting (or wishing to improve) the process of transition planning, think about all the areas that are critical for the success of your business over the long term. Spend your time and resources here rather than the mechanics of the transition. Once your team is ready to take over, then you can shift your focus to the deal itself.
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by Dale Gillmore
The average transaction takes less than a year to complete, but becoming “deal ready” takes years.
Every business owner wants to receive maximum value for their business at the time of their exit. That’s a given. Unfortunately, too many owners discover they have not put enough thought into a growth strategy to achieve that value, and they’re disappointed by the offers they receive when it’s time to sell. It doesn’t have to be this way. You can adopt sound strategies and practical techniques now that will positively position your business for transition. You just need some right information first.
70 to 80 percent of businesses put on the market don’t sell (Exit Planning Institute).
We think this failure rate is largely due to unmet owner expectations -- the surprises and disappointments they face from potential buyers at the time of transition.
No two businesses or owners are exactly alike, but many of the challenges they face as they endeavor to build maximum value – and exit on their terms – are similar. In working with business owners, we continually ask them to answer these 5 questions as we seek to build value and plan for transition.
What’s my business’ actual value right now?
Identifying value is the first step because it gives business owners a baseline measurement from which to track value over time. In other words, as they work to build (and hopefully maximize) value, this baseline number is there to gauge their success. If you cannot see increasing value, how can you know if the strategies you’re implementing are working?
But, the benefits of identifying your business value don’t stop there. Business value impacts the owner’s personal life, too, a fact often missed by business brokers. If you think your business is worth $15 million, but it’s only worth $9 million, that discrepancy will seriously impact your personal estate planning decisions and post-exit lifestyle choices. Wouldn’t it be better to know the reality of your business value far in advance of a transition, while there’s still time to do something about it?
What’s my real number?
Just as important as identifying value, it’s just as critical to understand now the approximate dollar amount needed to live the post-exit lifestyle you desire.
There are many variables that go into determining your number, but basically, we’re going to want to take stock of your future obligations, goals, and dreams. The tasks we must tackle include:
How can I eliminate risk to protect my business?
Business owners face a seemingly endless list of risks: lawsuits, regulations, technology, debt, customer concentration, human and intellectual capital, business model disruption, natural disasters, safety/compliance, embezzlement, death/disability, and cybersecurity, just to name a few.
The more risk that your business bears, the less someone will be willing to pay for it. Protecting business value, therefore, entails addressing and mitigating current and potential risk-related issues (business, financial, and personal). Have you begun that process? Do you even know where to begin?
How can I build value – in every way?
Building value is a necessary step for every business owner regardless of circumstances. Why?
Which transition option is best for me?
Again, every business is different. No single transition option fits the needs of every business owner. If someone is trying to sell you an “out of the box” approach to transition, keep moving.
From family/intergenerational transfers to management buyouts, sales to existing partners, third-party sales and even liquidations, there are lots of roads to consider.
Our passion at Quest is to educate clients on the options available to them so that they make the best decision -- a decision which can only be made by weighing each transition option against individual business, financial, and personal goals. Is your current transition advisor asking guiding you in this way?
If you have questions about maximizing the value of your business, you'll want to check out how Quest managed succession planning for this business. Remember, we are here to help align your personal and business goals.
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by Dale Gillmore
Prior to the 2017 tax reform bill, investors were able to utilize a popular tax-deferral strategy known as a 1031 exchange to defer capital gains on like-kind exchanges -- essentially disposing of one asset and acquiring another replacement asset to avoid generating a current tax liability from the sale of the first asset. Tax reform provided yet another strategy: investment in Qualified Opportunity Zones. Investors seeking preferential tax treatment of capital gains would be wise to consider investment into these economically-distressed communities.
How it works
Subject to the requirements below, a taxpayer can defer immediate recognition of the gain, and, depending on the holding period, get a reduction in the amount of gain realized through a basis adjustment and possibly eliminate tax on the realized appreciation in the value of the interest/assets held in a “Qualified Opportunity Fund.”
A Qualified Opportunity Zone is an economically distressed community that has been designated as a “qualified opportunity zone.” A list of qualified zones can be found here.
The steps and requirements are as follows:
Investment in Opportunity Zones provide significant planning opportunities for many investors and has the potential to generate additional long-term investment in areas most deserving. It may be a useful tool in capital gains deferral, particularly for individuals, funds, and companies considering investments in low-income communities, and could be ideal for private-equity funds and real estate developers for raising equity. At the very least, this new incentive program provides a capital gains deferral mechanism for short-term investments in a form that is more attractive than current Sec. 1031 like-kind exchanges.
The numerous requirements and technicalities to utilizing the Opportunity Zone tax deferral, as well as the factors involved in deciding where to invest, mean you shouldn’t make this decision alone. An advisory firm steeped in real estate investment strategy and tax savings strategies is your best bet. We're happy to help you get started.