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Preface:  Tax codes and their implications to partnership or operating agreements may be like deciphering hieroglyphics to some entrepreneurs yet the implications of a well-written tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement by working with your attorney to keep you in compliance with tax laws. Here are examples of how they can add value.

A CPA Can Provide Valuable Opinions on Partnership or LLC Agreements.

Credit: Donald J. Sauder, CPA

Business’s taxed as a partnership filing a Federal Form 1065 for tax purposes always involve more than one individual or entity in ownership. The “agreement,” whether a partnership agreement for a general partnership (GP) or limited partnership (LP) or an operating agreement say or an LLC, outlines the business rules and legally describes the business relationship with rights and responsibilities among ownership.

Often an attorney tailors these agreements as “boiler plate” papers that may omit certain key characteristics or be ambiguous on certain details of the business relationship, e.g. distributions of cash, buy/sell terms, earnings or loss allocations or management oversight. While a CPA cannot write a partnership agreement or operating agreement, (it would be prohibited as unauthorized practice of law or UPL); they can provide valuable insights into aspects of the business agreement document.

There is a story where Noble Prize winner Richard Feynman was visiting a Tennessee plant where the atomic bomb was to constructed. Feynman was confused about a unique symbol on the blue prints, and not being an expert on reading design prints, he needed to know what he did not understand. As an expert authority on the project he took a risk and ask “what happens if that value gets stuck”. He feared the answer might be a response that would make him appear ignorant to the group. The engineer assigned to answered needed to trace the blue print to answer his question, discovering a serious design flaw that could have destroyed the  Facility. When Feynman was asked later how he identified the problem, Feynman’s answer was “sometimes you just need to ask if it’s a value;” when in actuality he simply ask a direct question. Why hadn’t anyone else in the entire group asked? Moral: group collaboration has benefits. Feynman humble approach to understanding what he did and did not know was very helpful to the other experts.

One reason a CPA can provide value to business agreements is that they understand the tax aspects of the agreement. Some attorneys have tax expertise; but wordsmithing and tax are two different areas.

In corporate agreements or LLC’s taxed as S-Corporations, the distributions provisions per ownership in S-Corporations can be an important detail to tax compliance. For instance, what if a shareholder draws a disproportionate share of capital during the year? Does the agreement resolve the tax risk? Secondly the economic arrangement of distributions whether liquidating distributions or special allocations including preferred returns or guaranteed payments and tax distributions are best described and agreed upon at the signing of the partnership agreement. Thirdly, many agreements boiler plate 704(b) book capital with three safe harbors.

Typically well versed agreements hold the most value in challenging business ownership situations and therefore an improperly drafted agreements that doesn’t prioritize distributions of capital can lead to substantial risks for agreements in a liquidation, or restructuring, e.g. say an agreement provision requiring capital accounts to at all times be in accordance with Code Section 704(b) regulations and qualified income offset provisions provide clear details on what happens if a capital goes negative.

Guaranteed payments on capital or for services should be specifically outlined in numeric terms with schedules with addendum updates following to that the business relationship on capital is well documented, e.g. A CPA can help assess if rates on capital are necessary.

In addition, allocations of profit and loss and an agreement on economically accrued earnings and distributions of built in gains or basis step-up on ownership changes are all relevant to a well-crafted agreement.

Another item is Code Section 469 Regulations on economic groupings or activities, a business agreement should outline who has authority to make grouping elections for the business or decision making authority with regards to an appropriate economic unit. An agreement can even state that a tax filing must be made available before a certain day, requiring adherence to tax filing deadlines among management. A CPA can also help edit boiler plate documents to not require a partnership be bound by Code Section 754 elections for basis adjustment.

While some of the Code Sections and tax implications of partnership or operating agreements described above may be like deciphering hieroglyphics to some entrepreneurs, the implications of a well-written, tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement, by working with your attorney to keep you in compliance with tax laws.

While paper sits quietly for anything, a well-documented business agreement is well-advised for your business.

Preface: Why is working capital management important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost”. Working capital is the science of cash flow management – an important fuel to any business craft.

Investing to Double Your Business’s Value – Part IX

Appreciation for astute working capital management is pillar nine of doubling your business’s value. Working capital techniques are vital to any entrepreneurial business; the difference between current assets and current liabilities is working capital simplified. A business with deep pockets, has plenty of working capital. Yet too many entrepreneurs do not understand the term working capital, nor the value of expert working capital management. (If you’re an entrepreneur and your business advisor or CPA has schooled you in working capital management — please take the time to email me; no response is a vote.) Cash flow management is a more frequent term applied to the science; but working capital management is the appropriate application of cash management, i.e. trend setting.

Working capital is the fuel of business. Often your lead technicians, sales team, production supervisor, shop supervisor, or office staff are not attending to working capital or cash flow management, and yet calculating and maintaining optimal levels of working capital is imperative, and as important as good customer service, or product quality, for any business.

Working capital can be segregated into level one and level two balances. Level one working capital is a minimal balance of working capital required at all time. Dip below that level = fuel lights. While a business current ratio measures working capital metrics, it doesn’t give you a level one or level two balance requirement. Level two is peak working capital requirements for peak season cash requirements, e.g. financing holiday inventory levels.

Few entrepreneurs have an adequate understanding of what their business level one and level two working capital balances should be; and fewer have accurate accounting records to calculate the balance. In order to accurately calculate working capital, you need to account not only accurately for inventory balances and accounts receivables on the assets side, but also for current liabilities, e.g. portions of long-term, accrued payroll, accrued expenses; and of course, accounts payable. This requires accurate accounting records.

Working capital, or operating cash liquidity, can be measured with a formula of currents assets, i.e. accounts receivable days + inventory days – current liabilities, i.e. accounts payable days. Therefore if your average accounts receivables are 30 days and $50,000 and your inventory is an average of 50 days or $100,000 and your accounts payable are 20 days or $30,000, then the $50,000 + $100,000 – $30,00 is your working capital requirement, i.e. $120,000. If sales are $1,200,00 your business working capital is 10% of revenues. Inventory increases financing on a line of credit will increase both the numerator and denominator of the current ratio. Operating expenses financed with a line of credit will only adjust liabilities and equity, e.g. assets stagnate while liabilities increase.

Now you’re likely asking how is working capital management applicable to doubling business value? Each adjustment to current assets or liabilities is an adjustment to working capital or operating liquidity. Let’s consider a hypothetical scenario. If a business wants to expand and increase sales with the assumption of a $50,000 software development contract it will need to increase working capital based on the % of those additional potential sales, i.e. it is challenging to increase value without increasing revenues, e.g. you will need finance the cost of the contract either with customer deposits or other sources of cash say equity or debt.

For a service business that has only accounts receivables and accounts payable the scenario would work like this example. With $150,000 sales a month, and $145,000 of expenses per month, if receivables are 30 days and payables 30 days, then working capital before cash balances would be $5,000. In this scenario working capital would 2% of revenues, before cash is added.

A child once ask a successful businessman what was required to be in his industry. The response: Deep pockets. In accounting that is working capital. Software businesses that invest $4m say in development of a license must have adequate working capital to finance the start-up development and programming phase leading to implementation. If your business burn is $20,000 per year on start-up, you need working capital access to fuel the craft.

A secure business often has a current ratio minimum of 2.0 – 2.5 typically. This business’s current ratio would be a concerning 1.03, before cash. Therefore, unbeknownst to many, firstly, increased sales are connected to increased working capital, i.e. current ratio management. In this example, the business would need cash reserves of $140,000 before it should embark on a business expansion of sales revenues from a CFO advisor perspective, e.g. cash of $140k + AR of $150k / AP of $145k = current ratio of 2.0.

If the business has $20,000 of cash it should not plan to immediately implement to double business value. It should plan instead build a foundation of solid level one working capital, i.e. $140k of cash, before implementing increases in sales; and therefore associated overhead expenses.

Once the business builds the foundation of the accurate financial metrics, then it would need to calculate the sale increase and working capital requirements. In the above example the $1.8m of sales with $145k or working capital would equal 8% of sales. Therefore, for every $100,000 increase of planned sales would require $8,000 of working capital. Every entrepreneur should understand the science of working capital management to ease financial management and make more informed decisions. [Too many entrepreneurs rationalize financial performance without adequate financial oversight, i.e. analytical intelligence, resulting in non-optimal performance. The opportunity to access analytical resources for the entrepreneur with powerful accounting software is quickly changing the landscape of small business accounting. Authors note]

A good CPA is more than a qualified tax preparer or financial statement expert. For the astute entrepreneurs they are an advisor for financial decisions, with accurate financials as a map for business decision. To an expert CPA, financials provide insightful information that has substantial business value, i.e. well-advised decision making from financial metrics.

A business advisor consulting to develop your business should always rely on accurate numbers as a substantial factor in successful business decisions. Be very respectful of analytics and financial metrics, e.g. working capital calculations, because when appropriately applied, they can help you make very successful business decisions.

Again, why is working capital management so important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it? Lest haply, after he hath laid the foundation, and is not able to finish it, all that behold it begin to mock him, Saying, This man began to build, and was not able to finish.” Luke 14:28-30.

Working capital management in this blog context, is about proactively counting the costs when planning a doubling of your business’s value.

Part IX of doubling your business value– Working capital management.

Preface: Hobby loss rules are applicable to small activities, i.e. hobby farms. The following blog is pertinent to those who would like to deduct expenses on say small flock activities in the backyard.

Farm Hobby Losses Are an IRS Audit Risk

Credit: Jacob M. Dietz, CPA

Do you operate a small farm in addition to your main source of income? If so, does profit motivate your small farming operation? The answer to that question may determine how the farming operation is taxed. The question is not “is the farm profitable” but “is there a profit motive?” The tax law limits deductions for farms with no profit motive under the hobby loss rules. If you operate a small farm with a profit motive but no profit, then know what a hobby loss is, learn what the IRS factors into its decisions, and act to avoid the hobby loss classification.

Although the term hobby is frequently applied to the rules limiting deductions when there is no profit motive, the activity doesn’t need to be pleasurable. A taxpayer cannot escape the hobby loss rules by explaining that dealing with a frozen watering hose in winter is not pleasurable. The key is lack of a profit motive. Someone running a small farm on the side who never tries to turn a profit appears to lack a profit motive. On the other hand, a farmer sincerely motivated to make a profit but who suffers a loss due to crop failure is not a hobby loss farmer. The profit motive was there even if the profits weren’t.

So how does the IRS determine if there is a profit motive? The IRS lists some factors to determine if there is a profit motive. These factors are:

“You carry on the activity in a businesslike manner,

The time and effort you put into the activity indicate you intend to make it profitable,

You depend on the income for your livelihood,

Your losses are due to circumstances beyond your control (or are normal in the start­up phase of your type of business),

You change your methods of operation in an attempt to improve profitability,

You (or your advisors) have the knowledge needed to carry on the activity as a successful business,

You were successful in making a profit in similar activities in the past,

The activity makes a profit in some years, and

You can expect to make a future profit from the appreciation of the assets used in the activity.”

 

What can you do if you have a small unprofitable farming operation that is not your main source of income, but you have a sincere profit motive? First, continue to try making a profit. Second, demonstrate that you have a profit motive using factors listed by the IRS.

• Farm like it is a business. Track your income and expenses, and prepare reports showing how the operation performed.
• Track how much time you spend on the farming operation. It might surprise you, and the IRS, how much you work if you add up all those Saturdays and evenings.
• If you have another main source of income, then you might not be able to say that you depend on the farm for your livelihood. Losing on a single factor, however, doesn’t mean that there is no profit motive.
• If something beyond your control hurts your profitability, document it. You can’t help that a tornado ravished your corn right before harvest.
• If you are changing the crops you plant to increase profitability, document that change and your reason.
• If you have skill in farming, considering documenting it. Document attempts to gain farming skill, such as through reading, classes, talking with seasoned farmers, etc.
• If you made money farming in the past, keep tax returns or other records to substantiate that income.
• If the activity occasionally makes a profit, keep records of that. The IRS presumes an operation to have a profit motive if 3 out of 5 years, or 2 out of 7 years for some activities, it shows a profit. If you expect to make profits later in the 5 or 7-year period, but not at the beginning, you can file a form asking the IRS to wait until enough time has passed to apply the time test.
• If you expect to make profit by selling the farm, let the IRS know that if they question you. Perhaps you can show that the value has already appreciated since you bought it. Note that if you are planning to pass the farm to your descendants upon your death, then the appreciated value doesn’t help your case.

While the best way to demonstrate a profit motive is with profits, unfortunately that is not always possible. If you are trying unsuccessfully to make profits, then be familiar with the IRS factors, and try to document the ones that support your profit motive. If you have questions about your small farming operation and the hobby loss rules, talk to your accountant.

Preface: In business, journaling is useful for gathering data that can be applied in the future too. If you understand the purpose of reflections about business, and the value of working on your business, and not always in it, you’ll do well to read and apply the Harvard Business Review advice from January of 2016.

Investing to Double Your Businesses Value – Part VIII

Credit: Donald J. Sauder, CPA

Investing to Double Your Businesses Value – Part VIII is not about history being written in Word documents with auto saved features; it’s about you, having the opportunity to reflect on, and write, your own history.

Let’s reflect for a moment on a Harvard Business Review article from January 2016, that outlines the value of advised journaling in business leadership:

Research has documented that outstanding leaders take time to reflect. Their success depends on the ability to access their unique perspective and bring it to their decisions and sense-making every day.

 Extraordinary leadership is rooted in several capabilities: seeing before others see, understanding before others understand, and acting before others act. A leader’s unique perspective is an important source of creativity and competitive advantage. But the reality is that most of us live such fast-paced, frenzied lives that we fail to leave time to listen to ourselves.

Connect to purpose. All too many leaders have a surfeit of opportunities but suffer a paucity of meaning. Asking questions that bring us back to what is most meaningful to us personally, as well as to what we believe is most important for society and the planet, deepens our sense of purpose. For example, you might ask: What is my daily work? What is my life’s work? Similarly, reflecting in your journal on inspirational words from world leaders or wisdom traditions can act as an antidote to superficiality and parochialism

Gaining access to your own insight isn’t difficult; you simply need to commit to reflecting on a daily basis. Based on research (my own and others’) and many years of work with global business leaders as a consultant and international management professor, I recommend the simple act of regularly writing in a journal: 

https://hbr.org/2016/01/want-to-be-an-outstanding-leader-keep-a-journal

Journaling your business’s history as it unfolds, helps you see, understand and act before other entrepreneurs. It also, helps you understand yourself, your business and your marketplace. When reflecting on your business journal, you could quietly say; Hi! Stories of my Business! A journal helps you step back to avoid risks, and reflect to make more successful decisions in the future. A journal helps you navigate a common denominator or say numerator. Shifting from reactive business, to proactive business, requires the ability to see, understand, and act first.

One of my favorite stories is Rob McEwen, CEO of Goldcorp in 1999. McEwen was leading his company on discovering additional deposits at the Red Lake Mine in Ontario. In his search for inspiration from a demand for immediate exploration results, McEwen didn’t spend more time working on the business problem himself; instead he took some time to reflect, and traveled to MIT where he attended a lecture about open-source software systems.

Minutes after the lecture, he got an idea that worth billions. Applying a contrarian and vanguard approach, McEwen launched the Goldcorp Challenge. Sharing proprietary geological data with the public, he created a contest with a $575,000 cash prize: present exploration plans and techniques on where to find gold in Red Lake based on the data. Resource findings and results would award the winners. Millions of entries were submitted, within weeks, from mathematicians, graduate students, and experienced geologists. More than 100 targets, all hidden beforehand, were identified. The idea resulted in 8 million plus ounces of gold reserves; and a substantial world-class discovery.

In the minerals and mining business, exploration is for the purpose of gathering data that will be useful in the future, e.g. resource and reserve harvesting. In business, journaling is useful for gathering data that can be applied in the future too. If you understand the purpose of reflections about business, and the value of working on your business, and not always in it, you’ll do well to read and apply the Harvard Business Review advice from January of 2016. In 2014, did you journal where you’d be in three year? A thanksgiving and reflection are advised if that answer is yea.

Investing to Double Your Businesses Value Part VIII – Investing time to reflect on the past, and the present, while writing today your future business history.

Preface: Looking at your business through the eyes of prospective buyers, while working to double business value will likely improve profitability, (while you still own your company), and help you locate area’s that can increase value from a better understanding of how value is created, sustained, and successful transferred, i.e. doubled.

Investing to Double Your Businesses Value – Part VII

Credit: Donald J. Sauder, CPA

Exit planning for life after business, is a pillar to successful business strategy. Only the best of the best entrepreneurs get it right. You’re advised to exercise a plan to think about exit planning early for your business from the perspective of prospective buyers, even if you have only been in business a few years. It’s a necessary step to double business value, not to say managing your business like a great entrepreneur.

Exit planning usually is accomplished with a sale to family or a third-party, i.e. key employee. It is more than signing on an articulate will, or grooming a family member successor. The sooner you start planning a business exit, the more options, and opportunities your business will hold to harvest optimal value, and transfer business wealth successfully in an ownership succession transfer. Planning your exit from a business requires more thinking through a buy/sell agreement with an advisor, or obtaining continuity insurance. Although some entrepreneurs think exit planning is only necessary if estate or trust planning are required to effectively distribute business wealth, effective exit planning in the scope of doubling business value, is strategizing your business from the perspective of potential buyers.

In a third-party sale, you can have an enterprise sale or partial sale. A partial sale typically will result in the entrepreneur continuing to own from 80% to 20% of the business equity. Exit planning is often advised three to five before retirement, or a succession transfer, but the best entrepreneurs will plan the exit early, before it is even necessary. At least half of entrepreneurs exit their business unplanned; i.e. they haven’t prepared there business for a second generation life.

In addition to value creation, you should think about exit planning strategy early because people count on your business, e.g. if you’re a manufacture for a business, and a major source of vendor supply, your business should feel a responsibility to not domino problems for the business chain because your materials or services are not easily available elsewhere. Transition and exit planning is not self-centered, it’s responsible business; because transition risks are relevant not only to you, but your customers and clients too. Good entrepreneurship should advisedly include strategies to reduce exit risks to valued customers or clients.

Don Feldman, Sage advisor at Keystone Business Transitions, LLC in Lancaster, PA, has the following advice for entrepreneurs with regards to exit planning:

When valuing a closely held business, I frequently pose the following question to the business owner: what do you think the business is worth without you?  A similar question can be asked in regard to key employees:  what is the business worth without your key employees?   If they are critical to the success of the business their possible departure represents a risk to the business.

……The more difficult problem is when the owner is “key” to the business and can’t easily be replaced.  We see this most frequently when the current owner was the founder of the business and retains the principal customer contacts or the “know-how” essential to the business.

This situation is a good example of why, when I ask the business owner “how much is the business is worth without you” the best answer is “it doesn’t matter if I am running the business or not”.  This means that the business will have just as much value in the buyer’s hands as it does in the seller’s and it is relatively easy to sell the business.    However, we are frequently presented with a situation that is not ideal. The art of the exit planner is to be able to develop solutions that will work in the “non-optimal” case.

https://keystonebt.com/2016/09/key-employees-are-key-to-your-exit/

The purpose of planning or strategizing what your business exit plan is before beginning the doubling of value to your business is advised for two reasons, 1) Intrinsic business value is only realized tangibly with a successful exit from ownership; and 2) You need to understand what will encompass that value at exit, e.g. tangible assets; or intangible assets.

Looking at your business through the eyes of prospective buyers, when working to double business value will likely improve profitability, while you still own your company, and help you locate area’s that can increase value from a better understanding of how that value is created, sustained, and successful transferred.

Part VII of Investing to Double Your Businesses Value – think through your business exit plan today, from the eyes of prospective buyers.

Preface: The value of a business is often associated with the future value the business will add to its customers or clients, in its geographic marketplace. That value is a reflection of cash flows, net income, and asset values. A business valuation applies a fair market value assessment of that value contribution to the marketplace from a valuation model approach, i.e. the science; and adds the art of deal.

The Science and Art of Business Valuation

Credit: Donald J. Sauder, CPA

“Price is what you pay, value is what you get,” a famous Warren Buffett quote, is certainly most applicable to business valuation. Purposes of a business valuation, from setting value for buy/sell agreements, to obtaining bank financing for an acquisition, alternative financing, or exit planning in a transition, a look at what a business valuation process encompasses should be helpful for entrepreneurs.

Business valuation is both an art and science. With the science of the process and set of procedures applied to a valuation approach 1) Asset approach; 2) Market approach; 3) Income approach; and an art applied to the normalization of company activity, say with a controlling interest. There are as many specific values for a business as there are valuation experts, because business value means different things to different people. For investors, the value is based upon cash flows; for a strategic bidder, e.g. a vertical integration purchase, a business value is determined from consolidation metrics, or market share advantages. The circumstances surrounding the valuation report is part of the art, e.g. exit planning for retirement, relocation, or partners joining.

Albert Einstein is quoted as say, “Try not be a man of success, but rather try to be a man of value. This is true for business valuations too. A business valuation is not a success because the business value is the highest stretch, the valuation is a success because it is objective, independent and a fair market value; and a value achievable in a public marketplace bid. Business value, while both an art and science, is not saying that valuations reports should have substantial ranges in value; while each is unique and different, good valuations should be similar. Price expectations for a professional report usually include a value appraised for a fair market,

 

• i.e. fair market value: the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. {NOTE: In Canada, the term “price” should be replaced with the term “highest price.”} as define in Statement on Standards for Valuation Service No. 1.

 

The approaches to valuation are the methods for determining a business value. The Income approach include a profit multiplier or capitalization of earnings based upon normalized earnings of business. This approach is often used when a business has stable cash flows from year to year, and earnings or cash flows can be weighted for a number of historic year financial performance. The cash flows or net income can be multiplied or capitalized at either a pre-tax or after-tax performance metric. For an investor, it is important that your valuation use an after-tax approach. Why? You are purchasing the business for profit generation, and those profits will be taxed. Therefore, you must account the after-tax cash flows either for ROI (return on investment), ROE (return on equity), or credit financing repayments.

 

Another income approach is the discounted future cash flows. This method is often used for companies with variable earnings or variable cash flows, and requires the preparation of financial projections for discounted earnings of financial performance for a determined value, i.e. what is the value today of $1,000,000 of future cash flows in the next 10 years? The excess earnings method is a third income approach that applied an intangible and tangible rate of return on business assets, with multiple calculation metrics.

 

The asset approach is not based upon income or cash flows, but the net value of the business. This would be most applicable to real estate partnerships say, where the asset is most the business value.

 

The market approach to valuation, applies comparisons of other marketplace transactions to guide values. This approach required the valuator to access comparable market transactions, i.e. a BIZCOMPS or IBA Market Data, and compare similar size business transactions. The market method is subjection to differences to location, and management performance that influence appraised value. For instance, 10 business transactions with a value determined with the capitalization of income approach would result in 10 data points for the market approach BIZCOMPS sale price data. The subjective factors in those values would ultimately influence the market approach of a discretionary earnings multiple or multiple of revenues.

 

NACVA Standards have two types of value. A calculation of value and a conclusion of value. A calculation of value simply calculates and documents a calculation of a business value and is often a report between 18 to 34 pages. A conclusion of value requires economic and industry analysis and additional steps of documentation for the appraisal conclusion. A conclusion of value is often a report more than 50 pages required to appropriately document the business appraised value. Conclusions of value are required for litigation and compliance-oriented engagements, i.e. tax matters, e.g. gift tax compliance or estates.

 

“The value of an idea lies in the using of it.” Thomas Edison’s words could be rephrased for business valuations to say, the value of a business valuation lies in its marketplace relevance. The value can be modified annually from shifts in economic circumstances or transactional circumstances. The valuation report documents why that value is defensible, fair, and accurate.

 

In summary, the value of business is often associated with the future value the business will add to its customers or clients, in its geographic marketplace. That value is a reflection of cash flows, net income, and asset values. In a competitive market, there are few competitive advantages, and therefore, the businesses are somewhat comparable, e.g. the method or model consistently applied accurately determines appraisal value of the business. A professional business valuation applies a fair market value assessment of that value contribution to the marketplace from a valuation model approach, i.e. the science, and adds the art of deal.

 

 

 

Preface: Comparing your financial data to industry benchmarks may confirm strengths your business has in its sector or locale, and reveal areas for improvements. This blog is about tracking your business pulse with financial industry information.

Business Health Checkup

Credit: Jake Dietz, CPA

Is your company healthy? This question could be hard to answer. Even if you know your financial numbers, ratios and percentages, how do you know if they are vibrant? Different industries and fields have their own sets of benchmarks, or standards for comparison. For example, a 30% gross profit margin might satisfy entrepreneurs in one industry, but it might disappoint entrepreneurs in a separate industry. How can an entrepreneur or manager know if a business’s numbers and percentages are good? Compare your numbers to industry benchmarks to reveal strengths and identify weaknesses and then work to improve necessary areas.

Comparing your data to benchmarks may confirm strengths your business has in its sector or area. For example, suppose the industry benchmark is 30% for selling, general, and administrative (SG&A) expenses, but your SG&A expenses are only 20%. That indicates you run a leaner, more efficient operation than your competitors. That strength may help you weather a downturn that could put some out of business.

When you see your data beside an industry benchmark, you might also see where your company is weaker. For example, suppose the industry benchmark for gross profit percentage is 30%, but your gross profit percentage is only 15%.  Assuming your overhead is the same as the industry benchmark, then you need to sell much more just to make the same net profit percentage as the industry because your gross profit percentage is below the benchmark. A good time to call a financial physician? The company is not fulfilling its full potential, even if it manages to sell enough to be profitable. Good accounting is important in making these financial assessments.

Not only can benchmarks reveal weakness in profitability, but they can also reveal weakness in other areas, such as liquidity. Liquidity refers to a company’s capability of paying its liabilities in the short term. A company’s current ratio can be compared to the industry current ratio. A current ratio compares current assets (available within a year e.g. cash and accounts receivable or inventory) to current liabilities (payable within a year, e.g. accounts payable, accrued expenses or debt). If a company’s current ratio is much lower than the industry benchmark, then the company may struggle with cash flows to pay its bills.

It can be exciting to see how your company compares to the industry, but the greater benefit is to act on the information. If a weakness can be detected while it is still small, then you may be able to avoid a major problem. Look for ways to improve on that weak area. If the current ratio (current assets compared to current liabilities) is too low, can you keep more cash in the business instead of distributing it? Or can some expensive asset purchases be financed with a 3 year note instead of the line of credit? Perhaps a big change isn’t necessary, but small tweaks could help. Maybe some less necessary expenses could be minimized. On the other side, maybe revenue could be increased. The company may have certain types of work that are less profitable. If so, consider doing less of that work or charging more for it.

Comparing your company to a healthy industry benchmark may not automatically improve a company’s performance, but it allows the entrepreneur to see strengths and weaknesses and then adjust the company’s path accordingly. Applying industry and benchmark information to your company improves performance. Talk with your CPA for a business health checkup.

Preface: As you advertise your business, think of it as planting seeds. Plant your seeds on good ground, be diligent because you don’t know if it will be a 30, 60 or 100 fold crop; harvest at the right time, and then sell your crop at the right price.

Advertise Your Business for Success

Credits: Jake Dietz, CPA

Good advertising is like planting a small corn seed in good ground. A small seed planted now may later yield a bountiful harvest. Advertising wisely can increase sales and strengthen your business, but advertising poorly can waste your money and hasten business failure.  Before you advertise, develop a plan to track advertising success, close the sale, and monitor your prices.

Track your business as it comes in your door. If a customer calls, find out how they learned about you. Did they see your newspaper advertisement, did they see your truck driving down the road, or did they hear about you from a satisfied customer? Don’t waste precious dollars on useless advertising without knowing if it works. Track which advertising brings in the customers, and develop a strategy for advertising that targets those who will buy your products and services.

Advertising might get customers interested, but it may not be enough to close the sale.  Advertising is planting the seed, and closing the sale is harvesting. A bumper crop benefits the farmer after it is harvested. Is everyone on your staff that communicates with customers trained for sales? Everyone who has contact with the customer should know how to help close the sale, whether they sit in the office or fix sinks at the job site.

If a rude person answers the phone, or doesn’t offer helpful information, then the customer may go somewhere else. A customer might want something that you offer if they only knew you could do it. The technician or estimator on the job site can spot opportunities to better serve the customer. Never force a customer to buy something they don’t want, but inform them of the options. If a customer is asking to have a wooden deck built, do they know which options you have for decking other than wood?   Do you also offer deck lighting?

Selling products is great, but not when the price is wrong.  A bumper corn crop might be a great disappointment to a farmer if the corn price was only 20 pennies per bushel. Do you know what your costs of doing business are, not just the costs of the products you sell? If you buy a pipe for $9 and sell it for $11, then you just made $2. Or did you? Is that $2, along with the other profits, enough to pay employees, pay rent, and keep the lights on? If the prices are not high enough to meet costs, then advertising and increased sales may cause the business to fail faster. Monitor your prices so they cover your costs and earn a profit.

As you advertise your business, think of it as planting seeds. Plant your seeds on good ground, harvest them at the right time, and then sell your crop at the right price. This scenario benefits farmers and businesses. It takes work, but the harvest for your business can be worth it.

Preface: Being respectful of the high finance parable in the Bible, we’d say it is better to having taken business risks and lost, than never having taken business risk at all.

Investing to Double Your Businesses Value – Part VI

The Bible has very clear instructions in the world of high finance from Luke 19: 11-27. A nobleman goes on a journey and assigns three servants to invest money. Two servants take risk and one is fearful and takes no risk. The fearful servant likely has reason per the exemplified power of the nobleman; and two servants who took risk are successful, and promoted to high positions.

While there are different interpretations of Jesus parable, the face value moral is that risk in high finance, (i.e. applied to business) of taking risks is advised as less risky, than the risk in avoiding risks. Assumption: the servant’s position with that level of responsibility, certain training was likely par for the course.

Entrepreneurs assume risks too. Managing risk is Part VI of Investing to Double Your Business Value. Risk management is a multiple step continuous process. Identifying the risks is a first step to managing those risks, e.g. economic, operational, marketplace, and financial risks. Identifying risks before they develop is well-advised, but identifying risks before they become terminal is as vital.

In risk management one of the most problematic mistakes is a wrong diagnosis of the risk, e.g. a truck load of type writer ribbons at 50% discount, will be easily marketable. Marketplaces change and adapt, and entrepreneurs must manage the risks of those changes and adapt too. A more practical risks example is as follows. Are your business sales subject to consumer financing or only a discretionary consumer expense? What major enterprises drives commerce in your business locale or sales radius. What factors would change or influence your customers purchasing habits and therefore result in sales volume risks?

Risks will appear in your financial statements. Small business owners can sense risk. Larger enterprises must make decisions from the financial numbers. If you track accurately month-to-month financial performance, with a good understanding of how your financials work, you can identify and quantify risks immediately (with-in months), and begin working towards resolutions. This is step two of risk management – analyzing operational and financial data to quantify and assess risk development and implement quick mitigation. For instance, if your business MAP to increase sales, as a first step, is to hire one new employee, it is important to have a plan in place to track that performance with expectations. Or say, if your business is repairing lawn mowers, how can you track efficiency gains on that additional talent; or say what if you’re a lawn service technician, and a $700 robotic mower is introduced to the market? You need to identify trends early, and envision and respond to the risks.

Responding to risks and responses. The response to an early morning coffee or a missed train are different than responding to major customer transitions or marketplace innovation. Planning responses to risk is advised. For instance, if you’re acquiring a competitor to double business value, how can you minimize risks of cash flow on debt financing, if you simultaneously are increasing overhead with new employees. How will you respond to cash flow risks if a new employee requires three months training to perform billable work, and your projections are an unrealistic one month of costs?

Watching risks. You must always be alert for business risks. From project risk on a construction site, to office risks of cash management, an entrepreneur must be alert and continually monitoring risks. An awareness of risk, and the ability to manage risk, and not fear it, is important [emphasis added].

Being respectful of the high finance parable in the Bible, we’d say it is better to having taken business risks and lost, than never having taken business risk at all. Manage the risks. Talk with your trusted advisors. The fearful servant likely didn’t even have a conversation with a trusted advisor, or another servant, he seems to have simply trusted his own knowledge entirely. You have the advantage, because you can see and read and learn. At minimum, he should have likely set expectations with the nobleman. What are your business expectations and what are the risks in those expectations, i.e. double business value?

Part VI of Investing to Double Business Value – Manage Risk.

Preface: You need to be the cartographer for your business in an ever-changing business landscape;  your business skillset to map the right path forward in your industry will contribute substantially to future business value.

Investing to Double Your Businesses Value – Part V

Cartography is the art and science of making maps. Although the concept of a spherical Earth was well accepted by the time of Aristotle in 350 B.C. and has been widely accepted since, in ancient history, some map makers thought the world was flat. The oldest know maps in history are Babylonian clay tablets from 2300 BC, and since that time have been largely replaced in recent years with companies like Tele Atlas contributing to Google maps and LCD screen displays with programable features called a global positing system. With more 20 petabytes of data all from within three years, the twenty million gigabyte equivalent data sets are integral to business and personal transit today.

One certainty – maps have been a fundamentally important contributor to the development of modern society. We may take the value of maps for granted, but without them, reaching destinations would likely be more challenging.

Doubling the value of a business requires more planning than mapping a coast-to-coast trip. Entrepreneurial ventures too require a mapping of the business journey to doubling the business value, i.e. where will we start, where were we yesterday, where are we today, and where will we be tomorrow with regards to value?

A Business MAP, a Marketplace Assessment Profile, is a good tool to help you reach your business destination. A Business MAP is a business planning tool that helps you make sense of your business: the services and products viability in the marketplace, your business’s competitive advantages, industry risk, resource risks, opportunities, and value drivers. A Business MAP looks at your business on both a macro and micro scale and provides a guide for your businesses future. A Business MAP helps you plan your business destination, whether it’s organic expansion, a gear-up, etc.

1. Services: What does your business sell? Business is about selling products or services. Nothing happens in business without a sale. What are opportunities for the sales of products or services? What will you sell more of to increase sales and, therefore profits, or how will you add asset value?
2. Competitive Advantages: Monopolies have no competition. Likely your business doesn’t have the advantage, so what sets your business apart from the competition? What advantage does your business hold (or disadvantage) with locations or customers? What niche areas of sales provide an edge in the marketplace? What moat does your business own that secures and develops the value increase?
3. Industry and resource risks: What risks face your business? How will you manage the risks? What resource concentrations face your business – from vendor’s concentrations to fixed or variable expenses, what are the cost drivers; how can they be minimized? How can you reduce risks to add value?
4. Opportunities: What opportunities will increase gross sales, and net income or asset values; and, or, decrease liabilities to increase value?
5. Value drivers: What will drive the value increase in sales or assets in the marketplace? Will it be new markets, locations, sales teams, or acquisition of competitors say, or simply Fed policy?

A map is nice tool, but to apply the knowledge of the map you need a mode of transportation, fuel, and it helps to count the costs of the journey; naming a few of the advised travel planning steps. To double your business value, you a business MAP + much more. A business MAP is more than answering 5 question categories, and is beyond the scope of this blog. The above is only an introductory idea of what that strategic business mapping encompasses.

Summary: without mapping the steps to doubling your business value, good accounting, a well-trained talent pool, leadership or trusted advisors do not produce singular strategic ends. You are the cartographer in an ever-changing business landscape, and your ability to map the right path forward in your industry or business segment, will contribute substantially to future business values.

Step five to doubling your business value – a Business MAP