3 Sentence Summary
Author Greg Crabtree is a CPA who specializes in helping entrepreneurs take ownership of their financial data. This book teaches the fundamentals of owner compensation, profit targets, labor productivity, cash flow, and data reporting. Clear explanations and helpful illustrations throughout make it a must-read guide for small business owners looking to achieve higher profits.
5 Key Takeaways
- Get owner’s compensation right and stop playing games with distributions.
- Breakeven is 10% pretax profits.
- Labor efficiency is the key to profitability. Manage your salary cap and build a team culture around labor productivity.
- Forecasting is better than budgeting. Spend 75% of your time looking ahead at what you plan to make happen and 25% of your time reviewing actual performance.
- Understand the economic value of your business so you have a baseline for equity decisions.
Simple Numbers, Straight Talk, Big Profits! Summary
Please Note
The following book summary is a collection of my notes and highlights taken straight from the book. Most of them are direct quotes. Some are paraphrases. Very few are my own words.
These notes are informal. I try to organize them by chapter. But I pick and choose ideas to include at my discretion.
Enjoy!
Introduction
- This book is primarily aimed at business owners from startup to $5 million in revenue.
Free Tools
The author provides free spreadsheets and sample documents referenced in this book at his firm’s website: https://simplenumbers.me/profit-tools/
Section 1: The Four Keys
1. Owner’s Salary: Why Your Salary and Distributions are Fogging Your View of Net Income
- Don’t confuse business profits with owner salary.
- You get paid a salary for what you do, and you get a return on what you own.
- Until you pay yourself a market-based wage and plug that number into your financials, your financial data is worthless.
Keeping Uncle Sam Happy May Be Your Best Key Indicator
- Your tax bill is your #1 key performance indicator. The higher your tax bill, the better your business is doing.
- Don’t spend profits to lower your tax bill.
- Don’t focus so hard on not paying taxes. Focus instead on increasing your profits.
Determining A Market-Based Wage
- If you got run over by a bus today and your heirs decided they would keep the business going in your absence, what would they have to pay someone to do your job?
Salary Resources
A Business is Like A Cow
- If you’re not able to pay yourself a market-based wage, then you’re operating at a loss.
- Until you pay yourself a market-based wage—and make a profit on top of that you have a sick cow on your hands.
- Your goal should be to create a business that generates income for you every day (cash cow).
Sweat Equity
- Use sweat equity to compensate yourself when you can’t afford a market-based wage.
- Sweat equity is the value you have created for your business through your unpaid work.
Example
If your business should be paying you $100,000 per year for the job you perform in your business, and it takes you two years before you can draw your salary, you have just created $200,000 in capital through sweat equity.
This concept helps you calculate your lost opportunity to earn market-based wages had you chosen to work elsewhere.
If you have outside investors, it gives you a way to balance the worth of your effort with the money they invested.
Market-Based Wages For All
- A high employee turnover rate is very expensive.
- It also makes it hard to create consistency in the workplace, which can lower productivity, service quality, and customer satisfaction.
- Fair does not mean equal. Two people are rarely worth the same amount of money.
- Management by committee is an absolute failure as a business model. There has to be a clear leader even if the stock ownership is equal.
- When you’re in a situation where you’ve got two shareholders and there’s not enough profit for everybody to make a market-based wage, you need to account for it as debt as the unpaid salary builds up or as an accrued salary that wasn’t paid. If you don’t use either of these approaches, there has to be a shift in equity ownership.
Got Investors? Quantify Everything
Example
When you have a “money partner” (the owner who provides investment capital to the business) and an “effort partner” (the owner who works in the business but does not have money to invest in the business). If I’m starting a business with you and I have the ability to do something but I have no cash, I need a funder to put money in. This philosophy says that 100% of the profits and losses of the business should be allocated to the “money partner” until that partner recoups the initial investment. After that, you move to some agreed profit-and-loss percentage.
- Decide what your market-based wage is from the very start so you’re in agreement when the time comes to increase your salary.
- Not a good idea to share profits until after the investors are paid back.
- Quantify everything, and put it in writing.
Transitioning Out of Your Business
- If you’re paying yourself a market-based wage, it’s easier to step out of the role of being an active manager and into the role of being only a shareholder.
- You can hire your replacement with no negative impact on your net income.
- Usually best to ease out slowly. Consider a part-time role that pays less than your CEO salary, such as being a finance person or a customer advocate. Leaving abruptly usually creates a vacuum.
2. Profit: Why 10% is The New Breakeven
Profit is like oxygen—your business can’t hold its breath very long without it.
The Importance of Pretax Profit
- Pretax Profit = Total Sales – (COGS + Operating Expense + Interest Expense)
- Pretax profit is the profit you make after you take all your sales minus all your costs, before you pay taxes.
- Ignore EBITDA and focus on your pretax profit. Interest, depreciation, and amortization are real numbers that you need to consider in the profit calculation.
- If you can’t pay yourself a market-based wage, the first thing to focus on is getting your business profitable.
Gross Profit
- Gross Profit = Revenue – COGS
- Do NOT include direct labor costs in cost of goods sold.
- By keeping labor out of the equation, this definition of gross profit gets you the number that is the true economic engine of the business.
- Cost of goods sold typically includes pass-through costs like finished goods, materials, and subcontractors.
- By focusing on gross profit instead of revenue, most businesses from any industry can be compared side to side.
Contribution Margin
- Contribution Margin = Gross Profit – Direct Labor
- If I have labor that I want to account for as direct labor (that is, labor that is directly responsible for product or service delivery), I show it on a separate line below gross profit.
Breaking Even Isn’t Good Enough
- The target for pretax profit is 10%.
- By the time you’re at the breakeven point, your business is already dead.
- The best businesses operate between 10 percent and 15 percent.
Pretax Profit ($ of Revenue) | Business Status |
---|---|
< 5% | On life support |
10% | Ok |
> 15% | Great! |
The Eight Functional Areas
- Once you get to $1 million in revenue, you’d better be profitable and paying yourself a market-based wage.
- At $1 million in revenue, you can no longer take care of all the functional positions. You need enough revenue to cover the costs of paying market wages for people to perform in your business’s functional positions.
Functional Areas
Put the name of the responsible person behind each of these functional areas in your business.
1. CEO
2. Sales Management
3. Marketing
4. Operations
5. IT
6. Finance
7. Customer Service
8. HR
The Black Hole
- The “black hole” exists between the $1 million and $5 million in revenue.
- This is a time in your business growth when you’re forced to add staffing and infrastructure before you can really afford to.
- One of the keys to success is continually upgrading your staff.
- The need to add management infrastructure seems to naturally occur when you have about twenty employees typically, when you’re between $2 million and $3.5 million in revenue.
Hire With Care As YOu Grow
- Hire slowly, fire quickly.
- Use the topgrading concept of hiring when it comes to interviewing and selecting candidates.
- Use personality profiles as part of the screening process.
- Beware of hiring the “been there, done that” credential. Ask yourself why that person is available.
- A lot of my clients have had their greatest success with young talent who bought into the vision and the dream for the company. These young people are like sponges, and they want to absorb knowledge and information.
- Don’t take a trail-and-error approach to hiring. Follow a process and make an informed decision.
Book Recommendation
Your Capital Safety Net
- Your “capital safety net” is calculated by figuring how much cash you need to hire the people you need, then estimate how long it will be before your business can pay the new hires and still remain profitable.
- Prepare a cash flow forecast by month for the time period of the expansion to determine your capital needs.
- If you don’t have the capital, but still want to go on a journey through the “black hole” then you’ll need to raise capital.
Successfully Going From $1 Million to $5 Million
- Your goal is to still be profitable through this phase, even though you may not be as profitable as you were.
- Leave the profits in your business to fund the growth rather than relying on debt or investors.
3. Labor Productivity: Your Key to Surviving The Black Hole
The teams that win are the teams that get the most productivity for every dollar of labor.
- Focus on your gross profit per labor dollar as your key indicator for labor productivity.
- Stay at the 10% pretax profit mark every step of the way by adding labor only at the last possible moment.
- You can’t increase pretax profit by revenue growth alone. You improve your profitability by getting more productivity out of your labor.
- The profit curve should ideally mirror the revenue curve. As revenue increases, you should maintain 10% profitability.
- Beware of labor creep as you grow. This is when you start hiring more people than you need to take care of the annoying tasks in your business. To have proper labor efficiency you have to make sure that the annoying tasks are distributed to everyone in the company.
Determining Your Salary Cap
- Determining your salary cap is the best way to achieve your required labor productivity.
- Nonsalary costs includes all fixed and variable costs, including COGS, that are not paid labor.
- In the example below, your salary cap for the year is $500,000. This is how much you can spend in total on wages, including all salaried and hourly employees.
Revenue | $1,000,000 | ||
Salaries | ? | ||
Nonsalary Costs | ($400,000) | ||
Total Expenses | ($900,000) | ||
Pretax Profit (10%) | $100,000 |
Managing Your Salary Cap
- Managing the salary cap is the key to improving profits.
- If you are exceeding your salary cap, decide what to do about it. Are you going to hold wages constant until you hit your profit target, are you going to cut staff, or are you going to do some of both?
- Once you get to 15% pretax profit, then you can add employees to drive your profit back down to 10% again. Work your way back up to 15% and repeat.
- If you try to raise your salary cap when you have only 10% pretax profit, you’ll drive your profit down toward 5%, which is the danger area.
- Important to know what that 10% and 15% salary cap targets are for your business.
Profit Versus Cash Flow: Why Cash Is A Lagging Indicator
- When you start a business, there are only three ways to remedy the cash deficit hole:
- You can cover it with debt, but you have to use after-tax profits to pay it back.
- You can cover it with sweat equity instead of getting your market-based wage. But how long can you live with or accept less than a market-based wage?
- You can get an outside investor, but you have to either repay the investor with after-tax profits or have a good story to persuade the investor that your zero-profit business is worth a lot of money.
- Profit matters because it determines how fast you get out of the hole.
4. Business Physics: The Four Forces of Cash Flow
- Paying your taxes
- Repaying debt
- Reaching your core capital target (building working capital)
- Taking profit distributions
#1. Paying Your Taxes
- Before you spend money on anything, you have to set the taxes aside.
- Don’t pay taxes until you absolutely have to without incurring a penalty.
- But until you pay the taxes, you have to set the money aside and get it out of your financial calculations so you know it isn’t yours to spend.
Cash vs Accrual
Cash accounting is generally recommended for small businesses.
If you accounts receivable are usually larger than your accounts payable, then you should be on a cash basis. The only time you want to be on an accrual basis is if your accounts receivable are consistently lower than your accounts payable.
Exception: If you have inventory, you are generally required to be on an accrual basis, no matter what legal entity you are.
#2. Repaying Debt
- You can’t build wealth until you get out of debt.
- People who take a low- to no-debt approach can handle bad economic news because they live more stable and productive lives.
- If you borrow money, you have to forgo any after-tax profits because you have to repay debt with those profits.
- Do not confuse debt with capital. Capital is the cash you leave in the business to fund your receivables and inventory for normal business conditions, and debt is financing for special cases.
Lines of Credit
- A line of credit consist of a set amount of money that can be borrowed as needed, paid back and borrowed again.
- Best never to draw on your line of credit unless it’s used to infuse your business with cash during a temporary situation (e.g. supplement late payments that you’re reasonably sure will show up in the future)
Term Debt
- Term debt is a fixed monthly payment over a specific period of time.
- Used often to pay for an asset that can be depreciated.
- Better to have term debt than owe on a line of credit.
#3. Reach Your Core Capital Target
- As a general rule of thumb, your core capital target is equal to two months of operating expenses in cash and nothing drawn on a line of credit.
- Your core capital target forces you to pay for accounts receivable, inventory, and equipment with capital or term debt.
A Pearl of Wisdom
“One of my former partners had a client who was in the building supply business. The client was an old-timer who never had any debt and always had over a million dollars in the bank. We were talking to him one day and he said, ‘I love a recession!’ We were stunned. he continued, ‘I love a recession because I’ve got cash and I can buy stuff cheaper than anybody because they know that I can pay for it. I can work the deals while all my competitors go out of business. I’m the only game in town because I saved my money and they didn’t.'”
#4. Taking Profit Distributions
- Capital formation is the sum of sweat equity, money you invest, and after-tax profits that you keep in the business.
- Consistent profits over time allow you to build equity by keeping those profits in the business, which then allows you to hit your core capital target, which then allows you to have excess cash that you can take out without damaging your business’s ability to grow or deal with struggles.
- Before you take $100,000 out as a distribution, as yourself this question: “Is there something I can spend $100,000 on for the business that will get me more than $100,000 back?”
- If you’re not saving for a big business purchase, take the distribution and look at your personal life. Do you have debt or owe taxes? If not, then what’s your liquidity target?
- Most entrepreneurs who have businesses between #1 million and $5 million need to build up a foundation of $2 million of liquid, safe, core assets that give them stability no matter what they’re doing in life.
Section 2: Building On The Foundation
5. Taming The Tax Monster Under Your Bed: Tax Management That Works
Common Areas of Tax Fraud
- Paying yourself with distributions instead of a salary to avoid payroll taxes (S-Corps).
- Getting involved in offshore activities for the benefit of saving taxes only.
- Intentionally miscoding personal expenses as business expenses.
- Bartering by way of trading legitimate business expense for something that is for your personal benefit.
- Not filing tax forms for subcontractors.
Timing Is Everything
- You should be paying last year’s taxes with the tax funds you set aside last year.
- Each quarter, you should estimate how much taxes you owe on the profits and set that money aside.
- The IRS put the underpayment penalty in place to make you pay your taxes evenly throughout the year and not wait until the end of the year.
- Two ways to avoid the underpayment penalty…
#1: Safe Harbor
- You do not incur an underpayment penalty if you pay 110% of what you owed in taxes last year.
#2: Pay As You Go
- Make estimated payments on your taxes throughout the year.
- The only danger of this approach is that you can have really good first and second quarters but then have some losses in the third and fourth quarters. This results in your annual income being exaggerated in the first half of the year, so your tax payments for that time period may be larger than needed, and you will have to file your return before you can get your overpayment back.
Managing Tax Payments
“When I manage this for my clients, I have them pay the least amount possible under the safe harbor or the pay-as-you-go methods. I have them create a separate bank account to hold the tax money for any taxes they owe above the safe harbor method. If my clients’ taxes for the previous year were higher because their taxable income this year is down, I have them use the pay-as-you-go method. I don’t want them burning up good core capital by paying their taxes way too far in advance, which is what would happen if they used the safe harbor approach.”
Taxes and the Personal Side of Your Financial Life
- Pay yourself a market-based wage and withhold from that wage as if the business is going to make zero profits.
- If the business makes a profit beyond your salary, the business should make a tax distribution to cover the taxes it caused you to pay.
- There’s no terminology within the tax code that refers to a distribution as a tax distribution or a profit distribution. I use these terms to differentiate the purposes of the distribution.
- When you receive a tax distribution it is imperative that you don’t spend it on anything else. Either make an estimated payment or set it aside to pay taxes later.
- Your taxable income in an S corporation or an LLC is not based on your distributions (except in rare circumstances); it is based on your share of the net profit of the business, regardless of whether you take distributions or not.
- After tax distributions have been made, you can take profit distributions. use them to build your emergency fund and repay your personal debt until it’s gone. After that, you can start investing and building true wealth.
6. How to Maximize Your Labor Productivity
Opportunity is missed by most people because it is dressed in overalls and looks like work.
Thomas Edison
- The market affects the way you manage your salary cap.
- Gross profit per labor dollar is the second most important KPI for your business.
- Your target for gross profit per labor dollar depends on your calculated salary cap at 10% pretax profit.
Productivity From Every Dollar of Labor Spent
- If you aren’t at 10% pretax profit, use what you learned about managing and raising your salary cap in Chapter 3 to determine how much labor you need to cut or how much gross profit you need to add to get to that number, and then try not to add staff until you get to 15% pretax profit. This is how you control internal growth and profitability.
Can Culture and Profitability Coexist?
- Document your culture and how it ties into your profitability as a business.
- The more you document it, the easier it is to live it and maintain it.
- My COO sends an email at the beginning of the week that highlights one segment of our culture document to let everyone know what our focus of the week is.
- A company with great culture and no profits is going to die.
- You have to make sure your culture doesn’t excuse people from getting their jobs done.
The Salary Economy
- Companies that underpay employees tend to struggle in the long run due to high employee turnover.
- You also can’t assume that if you pay higher wages you’ll get more productivity.
- Never give employees a cost-of-living adjustment.
- What you pay them should be within a market-based range for their role.
How Market Forces Impact Salaries
- Years of experience often don’t count for much. The important thing is what people know and if they have the capacity to produce.
Using Salary Surveys
- Gauge market value by talking to your peers in the same industry and looking at local wage surveys.
- Salary surveys can help you define salary ranges.
- Establish salary ranges for each position at your company. They should take into account the required skill sets and education.
Evaluation Process is Key
- Your employees need to understand what is expected of them in terms of productivity.
- The best way to accomplish this is through the employee review process.
- You need to have a formal meeting with each employee at least twice a year.
- Focus on career planning and career path in employee reviews.
- Help employees understand that they are welcome to work at your company as long as you both are getting a fair exchange.
- It’s the responsibility of the CEO to provide employees with a vibrant environment, a fair wage, and a good culture.
Identify the top 3-5 skill sets for each role
- Don’t get too detailed with job descriptions.
- Focus on the top 3-5 skill sets that are required to maximize productivity for each job.
- As you do performance reviews with these skill sets in mind, you will be able to give more specific direction on how employees can improve their performance and how you can help them achieve their productivity potential.
Employee Evaluations That Will Drive Culture and Profitability
- How good a teammate is the employee?
- How well does the employee connect with external customers?
- How productive is the employee?
- Does the employee contribute at your targeted profitability levels?
- Core competencies: Have the employee’s responsibilities and skills increased?
- Don’t wait for a review cycle to adjust someone’s pay if their role/responsibility changes. Make the adjustment right away.
- Pay changes for only one of two reasons: If the salary economy changes and we adjusted the pay scale OR if they moved up a level.
Is Open-Book Management Right For You?
Book Recommendation
The Great Game of Business by Jack Stack
- OBM basically allows everyone in the company to see and talk about the company’s financial information..
- Employees become comfortable with the approach as they start to understand that they’re being paid a fair wage for what they produce.
- It forces you to talk through the perceived inequalities and deal with facts rather than rumors.
- If you and your management team are not comfortable explaining the numbers, I would not recommend using OBM. However, if you can become confident in explaining your data to your team, I think you will find OBMN very liberating.
Be Careful With Incentive Plans
- Throwing money at a problem doesn’t change the outcome.
- Most entrepreneurs look to incentive plans as a substitute for management and leadership.
- It’s usually more effective to use small amounts of money along the way to recognize outstanding achievement.
7. The Three Sources of Capital: How to Get Money and Effort to Play Nicely
- Capital (Equity) = What you own (Assets) – What you owe (Liabilities)
- Capital is used to purchase assets, such as inventory and equipment, and allows you to have the proper amount of cash on hand to meet your core capital target.
- Debt is NOT capital. The bank does not provide you with capital. They give you debt.
Source #1: Use Your Own Money
- Look to your own resources first before you go borrow money elsewhere.
- If you start a business with your own money, you’re going to defend it to the greatest degree.
Source #2: Other People’s Money
- Not all business can be funded with debt. Sometimes you need a long-term investor.
- Use investor money as a last resort.
- You tend not to be as careful because it’s not our money. It makes it easier to postpone the difficult decisions.
- When you use OPM, you have to be clear about the investors’ expectations and let them know you’re not giving them a salary. They get a salary only if they do a particular job within the business operation.
Friends, Family, and Fools
- Most common for businesses needing $100,000 or less to get started.
- Wise to draft legal agreements with an experienced attorney to avoid messy litigation if things don’t work out.
Angel Investors
- Most invest between $20,000 and $1 million.
- Angel investors are individuals, not venture capital firms. Can be a great source for capital.
- Research the track record of angels to see how they handle the ups and downs.
- Always pay to have a legal professional draft agreement documentation.
Venture Capitalists
- Most target businesses valued at $10 million or more.
- Similar to angels except investing is their primary business activity.
- They will demand a return on their money.
- They want to see revenue, demonstrable profitability, and growth.
Source #3: Sweat Equity
- Least understood and least measured form of capital (yet it’s the most common!)
- If you can’t afford to pay yourself a market-based wage for your efforts, then you’re going to have to defer payment and work for it.
- The trap that most people fall into is believing that because they have a low wage, they can live off the profits of the business. It’s better to live off your savings and let your sweat equity build capital in your business. Then pay yourself a market-based wage when your business reaches 2 or 3 percent pretax profit.
Example
“Suppose you started your business for $100,000 and your market-based wage should be $75,000 per year. You can create equity by working for no wages in year one, pay yourself $50,000 in year two, and be at a full wage in year three. That just created $100,000 of capital!
Exchanging Sweat Equity for Stock
- If you’re in a partnership as equal shareholders and you take a reduced salary compared to your business partner, then you should settle up with a transfer of stock.
- This should be done annually.
- Difficult decisions about business performance will be made sooner if you acknowledge sweat equity in this way.
Exchanging sweat equity for ownership
- Employees who become shareholders should be motivated first and foremost by the desire to get a return on their investment.
8. Reporting Rhythms: The Right Data At The Right Time
- Keep your reporting simple while still being able to recognize a flashing red light that indicates a problem.
- The more frequently you look at a report, the less data it should contain.
Daily Report: Cash Balance
- Include which customers paid and what the cash balance is after today’s deposit.
- Cash balance = the bank balance in your accounting system, assuming all outstanding checks have cleared.
- Delegate someone on your staff to provide a daily report that tells you who paid and what the cash balance is.
Weekly Reports
Cash Flow ForeCast
- Purpose is to make sure you have money in the bank when your bills are due.
- Shows a two-week projection of your expected sources of inflows and outflows.
- Break your payables up into five categories (add a few more as needed):
- General bills
- Payroll
- Payroll taxes and benefits
- Rent
- Payments for debt (lines of credit and fixed-term notes)
Example
“Let’s say today’s cash balance report shows $50,000, and this week’s cost and cash flow report shows you have only $10,000 in bills to pay this week. It looks good until you see that next week you need to cover a $50,000 payroll. The cash flow forecast report spurs you into action, and you look at what receivables you need to collect so you can make the payroll next week. Maybe you have to make other arrangements, such as drawing agains your line of credit. You have time to think about a solution because you have a two-week warning that there’s a problem.“
Quickbooks Tip
Use the vendor “due date” field to indicate when you need to have checks in the mail, NOT when the bill is actually due. Tailor the due date field to work with your payment processing procedures.
Sales and Productivity Report
- Watch this report on a weekly basis and then look at it month-to-date and year-to-date to see if the trends move in the right directions.
- Your labor efficiency ratio (gross profit per labor dollar) won’t change dramatically once your business model is set.
Monthly Reports
Profit and Loss Report: Monthly and Rolling Twelve
- One month P&L isn’t all that useful. Most useful P&L report is a rolling-twelve view. It shows every month ending a twelve-month accounting period.
- When you graph a rolling-twelve P&L, you begin to see the true trends of the business.
- Rolling-twelve data filters out all the excuses because the data has been through four seasons and includes every holiday.
- Keep the top level of your P&L very thin; roughly 7 lines of data, not including subtitles
- 5 common expense categories: Labor, marketing, facilities, payroll taxes and benefits, other operating expenses.
- Never print a P&L without looking at your balance sheet to make sure there are no glaring errors. An incorrect balance sheet makes your P&L worthless.
Know Where Your Cash Went
- You must be able to trace your profitability on the P&L to where the cash actually went (see Chapter 4).
- It’s possible to have a profitable business and run out of cash.
- Sometimes you have to constrict your growth to the amount you can fund yourself.
9. Economic Value: How to Know What Your Business is Worth to You
A profitable, cash flow-generating business is the best of both worlds; it is valuable to you whether you keep it or sell it.
- Knowing the economic value of your business helps you identify when the business is underperforming, what price it should sell for, whether or not you should keep it, and how to structure an offer for shares.
- There are many different opinions about the best way to determine the economic value of a business.
Blended Method (Cash Flow and Core Capital)
- The economic value of a business is typically based on the last three years of pretax profit plus the equity in a business.
- This approach takes into account not only the economic activity of the business, but also how well it is capitalized.
- The valuation will be lower if the business has a lot of debt.
Deciding to buy or sell in 50/50 Shareholder agreements
- If you’re going to buy 100% of a business, the maximum amount of time that you should be willing to wait to get your money returned, net after tax, is around 10 years.
- If the business has enough after-tax cash flows to return your money in that time period, then it’s generally a good deal to buy.
Economically Balanced Deals
- You want to be involved in deals that are economically balanced. The buyers know what they’re getting, and the sellers know they’re getting an accurate representation of the business.
- Only adjust equity in a valuation if the business has booked any assets or liabilities that are significantly over- or under-valued.
The Five Basic Elements of Value
- There are five basic elements that combine to drive the profits that are used to establish the value of your business: customers, employees, processes and know-how, core capital, and intellectual property.
- Profitability, salary cap management, and the four forces of cash flow are all contained these five elements of value.
#1. Customers
- Customer loyalty makes your business much more valuable.
- Without customers, you do not eat.
Book Recommendation
Customer Satisfaction Is Worthless, Customer Loyalty Is Priceless by Jeffrey Gitomer
#2. Employees
- The ability of a business to attract talent, train talent, and develop a functional team is one of the key drivers of business value.
- The right employees doing the right jobs give you labor efficiency that can beat your competition.
- Labor efficiency is the number one driver of profitability.
#3. Process and Know-How
- If you figure out a way to do something faster, better, and cheaper, then you’ve added intangible value to your business.
- This is the road map you give your team that helps them win the race every day because they take fewer detours.
- Process and know-how take raw want to labor and makes it even more efficient, which improves profitability even more.
#4. Core Capital
- Equity (Assets – Liabilities) represents the core capital.
- A business without core capital can miss out on good opportunities.
#5. Intellectual Property
- This is anything that can be patented, copyrighted, or trademarked.
- They do NOT belong on the balance sheet and should NOT be capitalized. R&D must be expensed as they occur.
- Only the buyer gets to book intangible assets.
- If protected properly, intellectual property gives you a window of opportunity to achieve above-market profit and increase your business value in the event of a sale.
Rule-Of-Thumb Calculations For Valuation
- All have their limitations and potential problems.
- At the end of the day, the value of a business is based on a willing buyer and a willing seller coming to an agreement.
Multiples of EBITDA
- Average buyers significantly overpay for business based on historical profitability.
- Flaws surface when you have a lack of earnings or a distortion of earnings due to incorrect owner salaries or discretionary expenses.
Multiple of Sales
- A multiple of sales is a huge leap of faith because not all sales are created equal.
- Probably the most inaccurate measure because you may have a different profit margin on every dollar of sales that runs through your business.
Discounted Projected Cash Flows
- A weak measure of value because everyone has a rosy outlook for the future.
Book Value or LIquidation Value
- Use this method when there are net assets in the business but the business isn’t profitable.
- Gives no benefit to the current owners for their stream of profits or lack of profits.
- Often used when there’s a damaged business and its worth is based on its net assets.
- When net assets are negative, it’s not uncommon for the business owner to pay someone else to take it over and get them out of the hole.
Examples of Economic Valuations
- Each year’s ROI is calculated by dividing pretax profit by equity.
- Under IRS rules, businesses can typically take a 10-20% discount for lack of marketability and a 10-20% discount for lack of control.
- The economic value in Company A is $1,405,500 in Year 5.
- A buyer who looks at how long it would take to pay for Company A, will see that an average payment of $158,400 every year, is 60% of the average of Company A’s NOI from the past three years. Remember, the IRS gets 40%, so the buyer can’t fund a payment with 100 percent of pretax profits. To make a payment of exactly 60%, the buyer needs to be fully capitalized because there’s no room to account for a year that doesn’t act according to past history.
- For the buyer who purchases Company A for $1,405,000, it would produce $158,400 per year, and at 7% interest to finance it, it would take 14.34 years to pay it off.
Important Note
“Resist the urge to give your stock to anyone. My experience with my own firm (and with clients) is that stock starts to have real value only when money changes hands.”
10. Skip The Budget, Learn To Forecast
A budget is a license to spend; a forecast is your road map to profitability.
- Forecasts only work if they go hand in hand with execution.
- Spend 25% of your effort looking at what has happened and 75% of your effort looking at numbers and thinking about what you want to make happen.
Annual Plan
- Create a plan for the entire year that outlines your expectations.
- What will be your annual revenue, costs, pretax profit?
- How will you spend your cash?
- Do it once, then put it away. Revisit it once a quarter at most.
Annual Forecast
- Create a forecast for the entire year.
- Update it each month as actual results become known and better information is available to forecast expectations for the remainder of the year.
- Keep it simple an answer questions such as:
- What’s my revenue?
- What’s my COGS?
- What’s my labor?
- What are my operating expenses?
- Once you’re fully capitalized, cash isn’t usually your critical number.
- Think more along the lines of how profitable you can be and if you can set a record.
- Don’t look at the metrics of other companies; set your own metrics and break your own records.
- Don’t buy or create a system (for reporting or forecasting) that requires far more effort to update than the value you get from it.
The Basics Of A Simple Forecast Model
Interpreting the Data (Accrual Accounting cash Adjustments)
- ⬆️ Accounts Receivable = ⬇️ Cash
- ⬆️ Inventory = ⬇️ Cash
- ⬆️ Payables = ⬆️ Cash
- ⬆️ Debt = ⬆️ Cash
- ⬆️ Shareholders Equity = ⬆️ Cash
Key Metrics
- A metric is more about movement than it is about the number itself.
- It’s more important to set and exceed your own company goals than it is to compare yourself to another company in your industry.
- Focus first on labor efficiency. Look at both month-to-date and year-to-date to spot trends.
- Next look at accounts receivable DSO, which is your A/R divided by your average daily sales.
- Another critical measurement is core capital. Most business should use the target of two months of operating expenses in cash with nothing drawn on your line of credit.
- You’re not fully capitalized until you’re out of debt and you have cash in the bank to cover two months of your operating expenses. You can’t take distributions—except for taxes—until you hit your core capital target.
Driving the Forecast
- Forecast months ahead and fill in actual data as it becomes available. Then reforecast the future.
- Forecast sales and gross profit percentage.
- Forecast all operating expenses. Use historical data to estimate.
- A/R is driven by your input for DSO.
- Input payables, debt, and capital injections/distributions.
Complex Cash Flow Model
- Graph revenue and gross profit on a rolling twelve basis.
- Gross profit is more important than revenue.
- Monitor the salary cap. Whenever the salary cap is below the adjusted labor, you had a lack of profitability.
- If your forecasts don’t prompt you to make changes before disaster strikes, you’ve wasted your time and effort.
- A full forecast model is built around a full presentation of profit and loss, the projected balance sheet, and the projected cash flow statement (including both historical and forecast data) and a dashboard summary to recap key metrics, so it shows the relationship between pretax profit and actual cash flow.
Questions To Answer with Forecast
- Where do you stand on profitability?
- How close are your sales targets?
- What are your operating expenses?
- How do you fare on your salary cap?
- How are your collections or DSO and receivables?
- Where are you in regard to your core capital target?
- Do you understand the tax implications of the profit?
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