Your P&L says that you are making money — but, do you know precisely where that profit comes from? More important, when a potential buyer asks you to explain the profit and how it can be grown, will you be able to answer these questions?
Understanding your company at this level of detail and being able to convey the information to buyers can make your company significantly more attractive to them, which will ultimately increase your company’s value.
What Questions Should You Be Able to Answer?
While my middle-market clients usually know whether they make money, many of them don’t have the systems in place to really understand what drives their profitability. Instead, many of these executives use intuition in place of data.
While the right questions to ask vary by company, middle-market executives often either don’t know which ones to ask or ask the wrong ones.
Moneyball, the book by Michael Lewis that was later turned into a movie starring Brad Pitt, is often used as a lesson in this kind of analysis. Prior to Billy Beane joining the A’s, traditional baseball management assessed players on the basis of whether they could run, throw, field, hit, and hit with power. Instead, the A’s adopted a new series of questions that attempted to better predict whether a player would help the A’s score runs, leading to more victories. This change in thinking brought significant success to the small-market A’s.
In business, the question “How do we generate revenue” is often the obvious and simple question, but it falls short. Increasing revenue does not necessarily equate to increasing profitability, since not all revenue contributes equally to profit. Instead, a business owner might want to ask questions like:
How much profit do we generate from each of our customers?
Which of our products generates the highest gross margin?
What is the gross margin on our individual projects?
What elements of our service contribute the greatest value to the company?
Buyers Are Metrics-Driven
In my experience, one of the key differences between the middle-market companies that I represent and the financial and strategic acquirers that buy them is the buyers’ considerable ability to add financial and performance discipline to companies that may not have it.
Often, this is the simple result of experience. While MBAs abound throughout private equity firms and the M&A departments of large corporations, many middle-market companies don’t have the luxury of having spare financial expertise that can be diverted from the key tasks of making money.
My clients are often hugely surprised during a transaction when the buyers ask the company to split and parse their data in many ways that they don’t (and, many times, didn’t ever) think to do.
Opportunities for Implementing Financial Metrics
The good news is that in many cases, implementing some relatively simple metrics can be relatively straightforward. By adding them to the company’s management reporting processes, the company can become more valuable to future buyers and make the company easier to manage.
A great starting point for analysis is segregating the company’s gross margin by customer. Often, companies don’t adequately measure the costs associated with each individual customer, taking the easy way out by allocating hard-to-measure variable customer costs into easier-to-deal-with GS&A buckets. Because in many cases the tools to do this sort of measurement aren’t even available, analyzing profitability by customer often requires some degree of estimating.
2. Revenue Category
Companies often provide products or services that vary in nature. For example, a company might provide different product types or sources or a blend of long-term and short-term services. Properly allocating the costs associated with these portfolios of products or services and tracking the profitability of each individual item allows a company to better determine where growth should occur.
Project revenue is a particularly difficult area for companies that are engaged in it. Adequately tracking costs and revenue over time to provide the company with an accurate picture of the company’s profitability is difficult. This analysis often first requires that the company establish an appropriate revenue recognition policy.
Finally, understanding profitability by sales staff is an obvious but often mismanaged effort when sales performance metrics are tied to numbers that aren’t themselves good indicators of profitability. For example, quantifying a salesperson’s sales to a particular customer only becomes useful if you understand the relative value those customers are providing to your company.
Rest assured that your buyers will do this analysis. I have been involved in more than a few transactions in which business owners were shocked at the analysis of their company’s profitability that a buyer discovers when looking at the internal data.
While ultimately this is exactly the expertise and value-add you want from a buyer, your company will be much more attractive and valuable if you implement some very critical financial metrics in advance of any transaction.