Month: January 2019

Preface: When you appreciate that all the factors that result in a higher business value will also result in a higher probability of a the continued success of the next generation of ownership, you have now realized the fundamental purpose of why your business is an investment.

Your Successor Looks at Your Business as an Investment (Segment II)

Credit: Donald J. Sauder, CPA |CVA

Commonly, many business owners think about a business transition, and how they will accomplish the next generation succession, and even retain an advisor to begin work on transition, e.g., developing the succession plan. Yet, that is only one step of many in a successful transition. One possible counter argument may be that the value of the business is not really that important to the seller, and only a cohesive working relationship with the successor owner is desired as shares transfer, hence the need for an advisor. While that reality may be true, (and this article is written towards the financial context of business transition) so is the fact that a business may transition for many reasons, e.g., owner retiring, relocating, pursuing new opportunities or interests, or generally looking for reduced responsibility with the existing business venture.

The point is, all the factors that result in a higher business value, will also result in a higher probability of a successful next generation of ownership. This includes, a stable and motivated management team, operating systems that improve and sustain cash flows, realistic growth strategies, diversified business risks and minimized revenue concentrations, growing earnings, and effective debt or working capital management. Is your business an investment? Yes, it is.

Small business organizations supply ownership with the cash flow and net earnings to provide for current and future personal and family expenses, gifts to the community (it is not an oxymoron that the synagogues are credited) and thirdly for most small family businesses, it often is the key reason they are most often financially secure, e.g., the successful management and investment of time, talent, and resources that accumulate and compound with the years. Note: unreasonable transaction values do create substantial financial pressures for buyers if the business transacts at a price substantially above fair market value, and cash flows shift in the business. While fair market value is subject to debate, realistic fair market value is not.

If you do not want to be a statistical failure with business succession, here is one advisor’s words of advice. “Consistently adhere to strong bedrock values and work towards a clear and united vision as a team. That is the best way to sustain a healthy (business) organization.”

A Keystone Business Transitions, LLC article written from the desk of Donald Feldman titled: The 7 Deadly Transition Sins, outlines the following awareness of business transition risks: abbreviated,

1) Failure to have a solid buy-sell agreement for multi-owner businesses. Businesses without such an agreement are playing Russian roulette.

2) Failure to have a business Continuity Agreement for sole-owner businesses. If the sole owner dies or becomes disabled, the business is at risk of dissipation. A well-crafted Continuity Agreement might empower your key employees to run the business and give them compensation incentives to do it successfully.

3) Failure to choose among children to manage the company. Sometimes children can work cooperatively as business owners, but parents are generally poor judges of this and it is advisable to bring in an outside expert to assess the situation.

4) Reluctance to relinquish control. This problem is sometimes most acute in family businesses when mom and dad are reluctant to hand over control to the children. The longer this reluctance persists (men are much worse offenders than women here), the more difficult the transition will be. As a rule, ownership transfers should begin no later than age 65.

5) Failure to think clearly about the tax consequences of ownership and management.

6) Failure to sell at the right time. Owning a business is an inherently risky enterprise. If you are at an age when you cannot afford to wait out a prolonged slump, you should sell while the market is good. The strong M&A market we have enjoyed for the last several years won’t last forever.

7)Failure to transfer ownership to the next management generation.

End of Segment II. To be continued.

Preface: When a business transition occurs, approximately forty-five percent of  owners will sell to a key employee or family member, and fifty percent will sell to an outsider; and roughly five percent of the businesses will not sell or transact at all….here’s what you need know for your future transition.

Your Successor Looks at Your Business as an Investment

Credit: Donald J. Sauder, CPA |CVA

Small business organizations in the United States contain both future opportunities and risks for enterprising talent and business owners alike. First, seventy-five percent of these small business organizations have a majority owner that is fifty years of age, or older. For most business owners in this majority it represents a business risk that statistically says fifty to seventy-five percent of the owner’s retirement net worth is in their business valuation  or the fair market transaction value of the business. Yes, most of these business owners factually have only ten to twenty-five percent of their net worth in investment assets outside the business e.g., an investment portfolio or 401k plan. Therefore, in many cases, harvesting that business value is crucial to the small business owner and their family’s financial future. Business value is much like an agricultural crop of wheat or corn, a successful harvest is not guaranteed but always anticipated.

“One of the common, substantial, and problematic factors in harvesting business value is the expectation of that business’s fair market transaction value to a buyer i.e., the appraisal.”

When a business transition occurs, approximately forty-five percent of these owners will sell to a key employee or family member, and fifty percent will sell to an outsider; and roughly five percent of the businesses will not sell or transact at all. Of those businesses , fifty percent plan to transition shares within three years and seventy-five percent plan to transition in ten years.

Beyond statistics, if you are one of these small business owners in the majority, preparing and planning your business transition is certainly advised and necessary. One of the common, substantial, and problematic factors in harvesting business value is the expectation of that business’s fair market transaction value to a buyer i.e., the appraisal. While this variable changes from year to year based upon net earnings, cash flows and EBITDA, customer concentrations, revenue propellers, and other factors relevant to the future probabilities of discretionary earnings in the business, tracking and benchmarking that value helps set proper transition expectations.

Setting appropriate expectations early is a keystone of successful ownership transition. Strategic business owners will value  their business at least twice before beginning a transition of ownership. This helps benchmark value expectations and sets a realistic foundation to optimize appraisal values for a future transition of business ownership.

“Too often, for most business owners, they approach business valuation as a second step in the transition process.”

There are multiple business valuation metrics, approaches and variables in appraising an accurate and fair market business value. For instance, the Asset approach will arrive at an entirely different value than say, an Income approach or Market approach, and a Market approach is subject to likewise variables in comparisons of product, market depth, and business locale. A realistic business valuation will include at least two comparisons of value in the report, e.g., an Income and Market approach.

Business valuation is more than financial analysis; it is an art and a science that requires appropriate expertise to obtain accurate fair market transaction appraisal value. It is at the capstone, a prophecy on  the future cash flows of the business, discounted to a current value.

Too often, for most business owners, they approach business valuation as a second step in the transition process. It’s alike to savoring a large ice cream cone on very warm summer evening, i.e. they forfeit the opportunity to maximize appreciation [value] on the sale of the business (the investment) with proper planning and performance improvements that can sometimes substantially increase harvest yields, i.e., the business value.

End of Segment I. To Be continued.

Preface: What is the benefit of all this management of accounts receivable and inventory and accounts payable, i.e. the cash conversion cycle components? Naming only two characteristics: 1) improved liquidity, and 2) more efficient use of working capital.

Cash Conversion Cycles (Segment II of II)

By Jacob M. Dietz, CPA

Inventory

Mapleberrytown looked at some industry standards that their accountant gave them for inventory days, and they realized that the industry is at 100 days. They reviewed their historical inventory days, and they realized that 1 year ago they were at 127, two years ago 115, and 3 years ago at 110. They are currently at 130 inventory days.

What can they do? Inventory management is a huge topic. The specifics of inventory management go well beyond the scope of this blog, but they could begin to look for low-hanging fruit. For example, are they overstocking inventory? If inventory is being stocked at too high levels, it ties up cash.

Mapleberrytown realized that they were stocking too much Widget Component B. Their lead time to get it is 2 weeks, but they have a 2-month supply on hand. When the person responsible for ordering was questioned about it, he responded that he is petrified of running out of the product. After sitting down and discussing the needs for that component, however, they developed a plan to have an appropriate stock level without tying up too much cash.

If inventory is a major component of your business, consider taking the time and really learning about inventory management. If inventory management can be improved, it can make a significant difference on the bottom line.

If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.

Accounts Payable

Last, Mapleberrytown examined their accounts payable practices. accounts payable days are subtracted when calculating the cash conversion cycle because it is a delay in paying cash. From a cash point of view, longer is better.

If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.

Mapleberrytown compared their accounts payable balances to previous years, and they discovered that the accounts payable days were steadily getting shorter. Next, they realized that their accounts payable days were below the industry standard. They are paying their bills faster than they did in the past, and they are paying faster than their competitors.

Mapleberrytown decided to go ahead and keep paying so quickly. One factor in the decision was that some of their vendors give them a 2% discount if they pay in 10 days.

Benefits of Shortening the Cash Conversion Cycle

What is the benefit of all this management of accounts receivable and inventory and accounts payable? One benefit can be less cash tied up in the business operations. If less cash is tied up in the business operations, then the business may be able to operate without a line of credit, or with a smaller balance on the line of credit. If the business has no line of credit and funds its operations with cash, then more efficient operations may allow the business to have more money in the bank to fund operations if times get rough. Furthermore, if a business is profitable and uses good cash management, some of that cash may be available to invest in business growth.

How healthy is your cash conversion cycle? Do you have money locked away that you wish you could access?

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

 

 

Preface: Managing cash flows adroitly is an important task to every business owner. Continuing reading to learn how the cash conversion cycle works, and what you should be aware of to optimize its role in monthly and quarterly cash flows. 

Cash Conversion Cycles

By Jacob M. Dietz, CPA

Imagine if you had $5,000 in cash, and you locked it in your safe. Unfortunately, you dropped the key into the bottom of a river while walking across a bridge. You call the safe company, and they agree to come and unlock your safe for you – in 15 days. That $5,000 is legally yours, and it is sitting right in front of you. You have every legal right to it, but it does you no good without a key. Understanding cash flow and taking steps to improve it can be a key to unlock cash flow.

Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable.

Cash Conversion Cycle

The Cash Conversion Cycle is a measure of how many days your cash is tied up in a noncash form during your business cycle. Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable. The specific calculations are beyond the scope of this article, but in general accounts receivable days are a measure of how many days it takes to collect your accounts receivable, inventory days is a measure of how long your inventory is around, and accounts payable days is a measure of how long it takes to pay your accounts payable.

Cash Conversion Cycle = Accounts Receivable Days + Inventory Days – Accounts Payable Days.

Suppose Mapleberrytown Widget Mfg, LLC is a manufacturing company that buys in widget components, manufactures widgets, and then sells the widgets to distributors. When they begin looking at their Cash Conversion Cycle, it is 150 days. Their accounts receivable days are 35, their inventory days are 130, and their accounts payable days are 15.

150 days = 35 accounts receivable days + 130 inventory days – 15 accounts payable days.

Accounts Receivable

First, let’s look at accounts receivable. Is 35 days good or bad? Compare the number your business’ historical trends and to the industry. In this case, Mapleberrytown Widget’s industry standard is 30 days. Their historical trends reveal that 1 year ago their accounts receivable days were 33, and 2 years ago their accounts receivable days were 32.

Both the industry comparison and the historical comparison indicate a problem. What can they do? In Mapleberrytown’ s specific situation, they realize that they some customers are paying in 50 or 60 days, even though the invoices are supposed to be paid in 30 days. Upon closer inspection of the invoices, Mapleberrytown realizes that they do not indicate a timeframe to pay them. They immediately started printing a note on the invoices indicating that they are due in 30 days. Mapleberrytown decided to send out statements every month to late customers asking for payment.

Conclusion of Segment I.