Thursday, February 16, 2012

Factor #2 of 10: Profit


Profitability/Positive cash flows

In the Self-Assessment, we asked you this question:

  1. Profit before Tax is calculated before bonuses, dividends, and adjustments for reducing tax consequences. Our profit levels have:
    1. remained pretty consistent for last 3-5 years.
    2. increased year over year for last 3-5 years.
    3. included 1 negative year showing a loss in the last 3-5 years.
    1. 2 or more negative years showing a loss in the last 3-5 years.
    1. been consistently negative over the last 3-5 years, we are structuring for growth or struggling to develop profit.

While there are many reasons to buy a business, the primary motivation driving the decision to buy is to receive the future positive cash flow as the return on investment. A business that is consistently profitable has a higher value and will be easier to sell than the business with marginal net profit or a history of profits and losses.

Typically the profit before tax number on your financial statements includes various year-end adjustments i.e.: bonuses, dividends, management fees, income splitting, etc. Modeling or normalizing the true discretionary cash flow or the “benefit to owner” allows the Buyer to understand the actual cash flow model for the business. The Buyer will use those numbers to calculate the proforma cash flows which enable completing a return on investment model.

Most share sale transactions will take those normalized numbers to build the criteria for establishing a multiple to set the transaction value.
For example: 3.5 X profit before tax (normalized average for last 3 years).
This means the Buyer will work for 3.5 years to recover the purchase price (breakeven), all things being equal.

When the Buyer reviews your year end statements and your year to date performance, they will be looking for evidence that all things remaining equal, the business will continue to perform as it has performed in the past. The more stable those numbers the easier it is for the Buyer to develop confidence in your model. When your business profits increase year over year for three or more years, the Buyers will recognize growth as part of the future cash flows. When profits are declining, that same trend will be applied by discounting future cash flows and reducing the price.

When those year-end numbers vary for whatever reason the business owner has to be prepared to demonstrate why that happened. The Buyer will need to know the likelihood the lower profit numbers will happen again. Then the Buyer will determine how much to discount the future return on investment numbers. In cases where one particular year was higher than other years, the Buyer will want to understand that case as well. It is important to remember that one year does not make a trend.

The variance in year-end normalized profits is a fact of life. Understanding those profits and why they vary will help the Buyer apply the best cash flow modeling rules possible. This helps the business owner and the Buyer develop a fair cash flow proforma which helps both parties build a realistic value for the business.

TO DO: What three priorities can you identify to improve your profit going forward?