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HOUSTON BUSINESS REVIEW
TUTORIAL ON SELLING YOUR BUSINESS "Enhancing Value – Financial Perspective Part II"
By Ralph Fain
Ralph Fain is a principal in the brokerage firm, R/Fain Group. Mr. Fain also has over 20 years of broad business experience with Fortune 500 companies. R/ Fain Group is a professional business brokerage firm which confidentially represents the interests of various sellers and buyers. Each week Mr. Fain will give tips on Business Brokering, and how to sell your business.
In last week’s article we discussed the need for owners of businesses to have a rudimentary understanding of accounting/financial/tax concepts and fundamentals and the need for owners to consult with their advisors on these matters on a regular basis. These consultations and resultant newly acquired knowledge will not only allow the business owner to take advantage of more favorable tax treatment for capital purchases (for example) but will also enable the owner to better forecast his financial and cash needs for the future and to better and more profitably manage his/her business.
We also briefly discussed cash flow and loosely defined discretionary cash flow (for our purposes) as net income (profit/earnings) plus “add-backs” for depreciation, amortization, owner’s/family’s salaries/benefits (particularly any excess amounts but in some cases the entire amounts), owner’s/family’s prerequisites (“perks”), significant one-time expenses, and, in certain cases, interest charges. We further touched upon the need for and importance of proper accounting and classification of company’s expenditures. With the foregoing as a preface, let’s now show the how and why of proper accounting and financial reporting.
First and foremost, let’s look at the accuracy, reliability and comparability of your financial statements. Do they show an improvement from year to year (steadily increasing revenue and profit) or do the results fluctuate wildly and widely? Are the fluctuations due to timing for tax reasons (i.e., so as to reduce the company’s taxable income and defer it to subsequent years)? Are the business ratios [e.g., percentages (%) of gross profit, etc] skewed and not comparable to industry norms? Was it due to accounting misclassifications? Have you made large one-time expenditures (i.e., software upgrades) that have distorted your profit picture?
The list of similar problems and issues goes on and on but the solution to improve the appearance of your financial statements in the eyes of the qualified buyer is relatively simple – analyze your financial statements for the last three years, perform variance analysis, and then, most importantly, “re-cast” your financial statements to correct any errors, to more accurately reflect your financial results and to better highlight your company’s strengths.
From a financial perspective, variance analysis is, in its simplest form, a methodology which detects “out of the ordinary”/”out of line” numbers or figures in your financial statements; these numbers may be out of line” when your company’s financial results are compared on a year to year basis and/or they may be “out of the ordinary” when compared to industry averages. Consider the following summary of financial results for the years 2002 – 2004:
2002 2003 2004
$ % $ % $ %
Sales/Revenues 1,000,000 100% 1,100,000 100% 1,200,000 100%
Cost of Goods Sold 570,000 57% 616,000 56% 860,000 72%
Gross Profit Margin 430,000 43% 484,000 44% 340,000 28%
Sales, General & Admin. 320,000 34% 352,000 32% 322,000 27%
Net Income 110,000 11% 132,000 12% 18,000 1%
In the above depiction, the trend from 2002 to 2003 shows a 10% improvement in Sales, a % increase in GPM and in Net Income and an overall favorable trend from year to year. The problems, however, begin in 2004. For example, your company’s Gross Profit Margin (Sales $ less Cost of Goods Sold $ = Gross Profit Margin $; Gross Profit Margin % = Gross Profit Margin $ divided by Sales $) was 43% in 2002, 44% in 2003 and yet only 28% in 2004. Something is obviously “out of line” with the GPM number here as it probably is with the Sales, General & Administrative expense for 2004 – 34% in 2002, 32% in 2003 and yet only 27% in 2004. In 2004 it appears that Cost of Goods Sold is overstated (too high) and Sales, General & Admin expense is understated (too low).
As you can readily see, basic variance analysis has highlighted a problem (or problems) which occurred in 2004 which require further research and investigation – depending on the results of the research, this may also (and quite probably will) require a restatement of the 2004 financial statement to accurately portray the results of the company for that year. Our next article will delve more deeply into the 2004 financial statement and show you how the product of variance analysis can result in a more favorable presentation of your company’s financial perspective and, hence, its valuation.
See you in this same space for the next article which will continue the discussion regarding improving the financial presentation of your company. As always, should you have any questions or require additional information please feel free to contact the R/ Fain Group at 832-646-0832 or via our web site.
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Ralph Fain Archive
- Buying a Franchise – Part 2 (March 2007, Issue No. 3, Thursday Edition)
- Buying a Franchise – Part 1 (March 2007, Issue No. 2, Thursday Edition)
- The 12 Step Process (August 2006, Issue No. 4, Thursday Edition)
- “More Fundamentals on Selling” – Non-Competes and Earn-outs (July 2006, Issue No. 2, Thursday Edition)
- “More Fundamentals on Selling” – Part III (June 2006, Issue No. 3, Thursday Edition)
- “More Fundamentals on Selling” – Part II (June 2006, Issue No. 1, Thursday Edition)
- “More Fundamentals on Selling” – Part I (May 2006, Issue No. 1, Thursday Edition)
- “Asset Purchase vs Stock Purchase” – Part II (February 2006, Issue No. 1, Thursday Edition)
- “Asset Purchase vs Stock Purchase” – Part I (January 2006, Issue No. 4, Thursday Edition)
- “Other Factors to Consider When Selling” – Part II (January 2006, Issue No. 4, Thursday Edition)
- “Other Factors to Consider When Selling” – Part I (January 2006, Issue No. 3, Thursday Edition)
- “Sale Structure – Stock Sale” Pros and Cons (January 2006, Issue No. 2, Thursday Edition)
- “Sale Structure – Asset Sale” Pros and Cons (December 2005, Issue No. 5, Thursday Edition)
- “Selecting A Business Broker” (December 2005, Issue No. 3, Thursday Edition)
- “Earnings and Multiples” Part IV (December 2005, Issue No. 1, Thursday Edition)
- “Earnings and Multiples” Part III (November 2005, Issue No. 4, Thursday Edition)
- Earnings and Multiples” Part II (October 2005, Issue No. 3, Thursday Edition)
- Earnings and Multiples” Part I (October 2005, Issue No. 2, Thursday Edition)
- “Valuation – What’s My Business Worth” Part II (September 2005, Issue No. 2, Thursday Edition)
- “Valuation – What’s My Business Worth” Part I (September 2005, Issue No. 1, Thursday Edition)
- Preparing Your Business for Sale/Enhancing Value – Summary (August 2005, Issue No. 3, Thursday Edition)
- "Enhancing Value – Financial Perspective Part VII" (August 2005, Issue No. 2, Thursday Edition)
- "Enhancing Value – Financial Perspective Part VI" (August 2005, Issue No. 1, Thursday Edition)
- "Enhancing Value – Financial Perspective Part V" (July 2005, Issue No. 4, Thursday Edition)
- "Enhancing Value – Financial Perspective Part IV" (July 2005, Issue No. 2, Thursday Edition)
- "Enhancing Value – Financial Perspective Part III" (July 2005, Issue No. 1, Thursday Edition)
- "Enhancing Value – Financial Perspective Part II" (June 2005, Issue No. 4, Thursday Edition)
- "Enhancing Value – Financial Perspective Part I" (June 2005, Issue No. 2, Thursday Edition)
- “Preparing Your Business For Sale – Part IV(B)” (May 2005, Issue No. 4, Thursday Edition)
- “Preparing Your Business For Sale – Part IV(A)” (May 2005, Issue No. 1, Thursday Edition)
- “Preparing Your Business For Sale – Part III” (April 2005, Issue No. 4, Thursday Edition)
- “Preparing Your Business For Sale – Part II” (April 2005, Issue No. 3, Thursday Edition)
- “Preparing Your Business For Sale” (April 2005, Issue No. 2, Thursday Edition)
- Tutorial on Selling Your Business “Why Am I Selling”? (March 2005, Issue No. 5, Thursday Edition)
- Why a Business Broker (March 2005, Issue No. 3, Thursday Edition)
- Buying and Selling Businesses (and Related Topics) (March 2005, Issue No. 2, Thursday Edition)
- Who Is Ralph Fain? (March 2005, Issue No. 1, Thursday Edition)
- Utilizing A Broker, Benefits To Seller (February 2005, Issue No. 4, Thursday Edition)
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