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The Second Component Of Value – Profitability (Part 3 of 7)

2 February 2008 No Comment

The Second Component Of Value – Profitability

You already look at your bottom line. You’ve watched it for years and it usually goes up. You will often hear about companies being priced as multiples of profit so the higher your profit, the higher the value of your company. If you’re like most business owners you also know there are things you can do to increase your profits – things that are obvious (to you), things that you know would work and just haven’t gotten around to doing. Every business owner has plenty of ideas for improvement and not enough time to do them all. In your mental calculations you add those profits to your bottom line in your own estimation of value. Buyers like to see those opportunities as well, for a different reason. They see additional profits and value that they will create once they own the company. They only look at historical numbers in their assessment of what to pay you and figure anything in the future will come from their efforts and investment. You may both agree your business has tremendous upside, just don’t expect them to pay you for it. (There is one exception that we’ll cover in the next section.)

Your first priority is that bottom line. Maybe you’ve even done some analysis, looking at your ROA, ROE, D/E ratio, EBITDA, and the like. Perhaps you’ve compared your company to others in your industry. If all this is greek to you make an appointment with your CPA or banker so they can explain it to you. They’ll be able to help you more if you’re conversant with these concepts, and they’re already using them on you anyway. Profit is good, and more is better – not a difficult concept. Smart buyers have another view as well – quality of profit. Quality of profit moves in advance of quantity of profit, which is what you see on the bottom line. If all you see is the quantity, you may be looking at an increase the same way you would see a nice addition onto your home – only to realize too late that the foundation has termites. You already brag about the quality of your products and the quality of your people. Once you start looking at the quality of your profits you will have one of the most powerful financial management tools at your disposal – and one that not many other people know how to use. Quality of profit also gives you some insight into the next component of value.

What to do now:

  1. Start collecting the data so that you can analyze your quality of profit.
  2. Compare your company to its industry peers and look for areas of improvement.
  3. Get a simple valuation done so you can see how the basic financial metrics affect your total enterprise value.
  4. Prioritize and begin implementing operational and profit improvement tactics.
  5. Measure your cash flow and cash cycle so you’ll know how you will be able to afford growth.

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