Stability of Historical Earnings

No other element of the Multiple of Discretionary Income Formula has as much weighted value as the historical earnings of the company. Every knowledgeable business entrepreneur, accountant, lawyer, broker, you name them; they look for this information first. There’s a reason for this. It really identifies the value of the company overall. If you are really interested in taking your company forward and want to increase the value, get this aspect of your business in shape. I’ll illustrate the importance on both sides of the Multiple Discretionary Income Formula. From there, I’ll provide guidance in how to make improvements and ultimately how to make major leaps forward in your reports changing the value of the business.

The primary tool to evaluate a business’s worth is the Multiple of Discretionary Income Formula. In essence it multiples the real net income of the business operation by a risk factor to calculate the value of the business operation. There are two inputs to the formula, the first is the discretionary income which is really the net profit of the company calculated from the perspective of a third party owning the business. The second input is the risk factor. This is a formulated number between zero and three. There are 10 risks in every business. The most weighted value risk is the historical earnings. A buyer of a business is looking for stability in those earnings. That is, no major fluctuations that would indicate problems or one time significant windfall.

The formula is a multiplying formula whereby DISCRETIONARY INCOME x RISK MULTIPLIER = VALUE. Read more about Discretionary Income Multiplier Formula here: Business Value Calculation . The secret is that the earnings of the business operation affect both sides of the formula and therefore, any increase in this greatly impacts the final outcome.  The weighted value of the stability of earnings is around 18% of the total final risk factor number. Therefore, if your earnings increased about 15,000 per year, it would increase the stability factor enough to cause the overall multiplier to increase about 7%. This is significant in dollars. Let me illustrate:

       Discretionary Income   Risk Multiplier   Business Value
Before      $100,000               1.76                          $176,000
After          $115,000              1.8832 (7% increase) $216,568

A 15% increase in stability of earnings from $100,000 to $115,000 per year equates to a $40,568 ($216,568 – 176,000) increase in value for the business. This is beyond significant; this is a real value increase. The best correlating example is a $4,000 paint job in your house prior to selling it. Does it pay you back? Yes it does and more. Now let’s give your business a new paint job! 

Just like a paint job, your financial information needs to look pretty. Not only must it display really great numbers, but it needs to shine and stand out. What I mean is that the reader can easily understand what he is reading. Many small business entrepreneurs have a very poor format and layout of their financial information. The story in the sidebar below brings home the point I want to make.

As with the paint job, you should hire a professional. Yeah I know: those accountants don’t know what they are doing and/or they are just too expensive. Most CPA’s know what they are doing but don’t really want or have the time to do a cleanup job on client software. To make matters more complicated, there are a lot issues involved in professional compliance specifically maintaining independence etc. You need to find a really good accountant that understands the software you use to begin the changes. The key is to create a reporting format that even your seventh grader can understand when he reads the report. When engaging an accountant to perform the task, ask them, how would you report the information? Does it tie together easily? Can a layman understand the reports? 

Now that you have a good format developed, begin the process of reclassification or modifying the information to be in compliance with the new format. This is usually the time consuming part because you will want to go back at least two years or more to classify the data or transactions in the correct accounts. Test the outcomes of the data and confirm that it reads correctly and well. Now you have the foundation to make changes.

The first set of changes should be in depreciation.  A simple step of reducing the depreciation amount increases the bottom line. It is simple math, reducing an expense increases the profit. Depreciation is one of those judgment expenses. If you are like most business owners, your depreciation is based on tax formulas. Tax depreciation uses accelerated values to reduce your tax obligation. Convert your books to straight line depreciation.

Next, make sure you are using accrual accounting and not cash accounting. If you are currently under accrual accounting, confirm that it isn’t some form of modified accrual accounting. The key is to maximize revenue. Accrual accounting makes sure that all revenue is included. This means that any project income is added to the financial reports as revenue based on the percentage of completion method.

Confirm the cost of goods sold section. If inventory is an element of setting the value of the costs of goods sold, was it properly done and calculated. To make changes to the P&L in the current period, an accurate inventory should be conducted to verify the balance and the true amount to be recorded and reported in the Cost of Goods Sold Section.

Review the receivable write-offs. Consider pursuing legal processes to collect some of that money. Remember the formula from above. Even $2,000 to $3,000 in collections has a 2 to 3 times increase in value for the company. 

Look at any one time expenses that made a significant change in the bottom line. Maybe a legal matter or a major repair; can this be depreciated or amortized over a period of time to level the expense and increase the bottom line value on the profit and loss Statement? Do you have some type of program income where by you put up some large outlays for investment via research or some development? Can this be amortized over time?

The best way to do this is to have your CPA look at the financials and give you some advice on how to improve and stabilize past profits and current year profits. He can more fully explain these suggestions and if he knows your business and industry, give you even more helpful suggestions than those I have provided.

Remember the goal here. You want to have stable and increasing net profits over a historical period of at least 3 years. Reports should be easily readable and understandable by the potential buyer, investor or banker. 

Another area of financial reports is the balance sheet. Any reasonable businessman in your industry should be able to look at the equity section and ascertain the performance of the business. Make sure the report has good classification for both sides of the balance sheet. List the assets in order of liquidity from cash to low on long term performing assets (deposits on facilities, escrow monies, and long term loans made to 3rd parties). In the liabilities area, be clear what is owed for production issues such as inventory and vendors, a separate area related to payroll such as taxes and benefits due, and another area for short term notes, lines of credit, or credit card debt.  In addition, identify long term debt and then the equity section. The Equity Section should look like this:

Capital Stock at Par Value                                        ZZZ
Capital Paid in Excess (Contributed Capital)     ZZ,ZZZ
Accumulated Earnings (Lifetime)                    ZZZ,ZZZ
Distributions/Dividends (Lifetime)                    ZZ,ZZZ
Retained Earnings                                               ZZ,ZZZ  (Accumulated less Distributions)
Current Earnings to Date                                      Z,ZZZ
Total Equity                                                    $ZZZ,ZZZ

Notice this separates the capital contributed and paid in by the owner(s) and the amount earned since inception less the amounts paid back to the owner(s). The key is to make this as clear as possible allowing the reader to grasp that the company does provide for the investor or owner(s). Now your paint job is done! This is the stuff you want to be proud of at the end of the day. Make it easily readable and you hear great comments from other businessmen. In addition it helps you to grasp the value of somebody else’s business. When you know more, your wealth will increase. Act on Knowledge.

Residential Construction

My client used QuickBooks Accounting for bookkeeping. He builds around 3 houses per year, does about 6 additions per year, and about 20 repair jobs per year. His income statement reads like this:

Contract Income                        ZZZ,ZZZ
Expenses (long list of items)     ZZZ,ZZZ
Net Profit                 Usually a negative # because he had difficulty generating profits.

I decided to convert this to a job costing format with 3 classes of income: New Home Construction, Additions, and the third, Repairs/Modifications. He had 3 Sub Profit & Loss Statements each has this format:

Contract Revenue                               ZZZ,ZZZ
Costs of Construction:
  Materials                                ZZ,ZZZ
  Subcontractors                       ZZ,ZZZ
  In-house Labor                         Z,ZZZ
  Insurance                                  Z,ZZZ
  Transportation/Equipment       Z,ZZZ
  Licenses/Permits/Supplies          ZZZ

 Direct Margin from Contracts            Z,ZZZ

The Master Profit and Loss had three columns that tied to the Sub P&L’s with each column listing the information from above.  In the Total Column I listed the general operating expenses. The report looked like this:

                               New  Home       Additions        Repairs             Total
Contract Revenue      ZZ,ZZZ             ZZ,ZZZ         Z,ZZZ        ZZZ,ZZZ
Costs of Contracts:
   Materials                 ZZ,ZZZ             ZZ,ZZZ        Z,ZZZ        ZZZ,ZZZ
   Subcontractors         ZZ,ZZZ             ZZ,ZZZ        Z,ZZZ          ZZ,ZZZ
   Labor                         Z,ZZZ               Z,ZZZ        Z,ZZZ           ZZ,ZZZ
   Insurance                   Z,ZZZ                  ZZZ            ZZZ             Z,ZZZ
   Transportation               ZZZ                   ZZZ            ZZZ            Z,ZZZ
   Licenses/Permits           ZZZ                   ZZZ              ZZ            Z,ZZZ
Gross Margin                Z,ZZZ                Z,ZZZ           ZZZ          ZZ,ZZZ
Expenses (office,  facilities, communications, etc.)                       ZZ,ZZZ
NET PROFIT                                                                                  (Z,ZZZ)

With this information, the client could identify the division of his contracting company that was causing the loss each period. I took this one step further and implemented job costing. This allowed him to pin point the one or two jobs he took a beating on and why. I used phase accounting in all three divisions to assist him in where he did well and where he had estimating issues. It took him two years to get it turned around, but from that point forward he has done really well. Information is clear and understandable.

© 2013 – 2022, David J Hoare MSA. All rights reserved.

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