Do Not Let Cost of Goods Sink Your Exit Plan

Exiting on Your Terms — Do Not Let Cost of Goods Sink Your Exit Plan


So How is it that Cost of Goods Can Sink Your Exit Plan?

A common concern that arises during due diligence, when a business owner is attempting to close on the sale of their business, is period-to-period historical fluctuations in cost of goods.  Though the focus in due diligence is on fluctuating gross margins, how businesses account for cost of goods is really the root cause of the fluctuations.  Remember gross profit is computed by subtracting cost of goods from revenue or income.  Potential buyers are seeking businesses with historical gross margins that are predictable over time and consistent with the acquisition’s industry cohort and with luck increasing.  When we say do not let cost of goods sink your exit plan, what we really mean is do not let large gross margin fluctuations detrimentally impact your valuation.  This is a brief discussion on the problem and some potential fixes.

Highly variable gross margins can be indicative of underlying business process and accounting issues that will potentially impact the acquirer’s confidence in the sellers.  Problems of this sort will frequently result in price reductions or can kill the deal all together.  The intent of this article is to help business owners better understand why buyers/investors are concerned with this issue and what can be done to ameliorate the problem before it sinks your exit plan.

Do not let cost of goods sink your exit plan. Take action to ensure you maximize your company valuation to exact maximum value from your business sale. Click to Tweet

What Exactly is Cost of Goods?

In a product-based business, cost of goods represents the capitalized cost of inventory that has transferred from the balance sheet to P&L.  This primarily occurs as units of inventory are shipped to customers, but can also occur as scrap transactions or cycle counting adjustments. 

In accounting terminology, inventory dollars are “unexpired†cost, meaning the cost is idling on the balance sheet.  Once an inventory item is sold or shipped, the related inventory dollars become an “expired†cost as title of inventory passes from the seller to a buyer.  So I guess you could state that an expired cost indicates the benefit and risk of ownership associated with an inventory item has transferred from the business to a customer.

The inventory cost of an item includes at least one of the following costs: 1) direct material; 2) direct labor; 3) overhead expense; 4) subcontract costs; and 5) material overhead.  A manufacturing business transforms raw materials and other costs into new items that have greater value the cost of the constituent parts.  A distribution company generally does not add value to the inventory items purchased for resale.  The cost of goods for a manufacturing company and distribution company is movement of inventory and inventory costs passing from the balance sheet to the profit and loss statement.

This concern can also affect service businesses, but that will be the focus of a future article.  But again widely fluctuating cost of goods can sink you exit plan even in service businesses.

Why Should I Be Concerned About Gross Margins?

Business owners contemplating the sale of their businesses need to be aware of the perception buyers will have when reviewing historic gross margin trends, which again is really driven by cost of goods, that appear uncontrollable.  Here are a couple of questions that I ask my clients to assess their business processes relating to inventory costing: 

  • How frequently do you review and update product costing?  Product costs should be analyzed at least annually with significant changes occurring at year end.  Try to avoid revaluing inventory standards during midyear unless the change is material.
  • Can you describe what costing methodology is used to generate product costing?  Are you using average costs, standard costs, FIFO or LIFO?
  • What are your policies regarding obsolescent, expired and excess inventory?  If you have a policy, what provisions have been set aside for this type of inventory?
  • How do you handle production variances?  Do you capitalize and amortize them over an inventory turn, or let variances flow to the P&L as incurred?
  • Do you have a cycle counting policy?  If you do, what have the cycle counting results been over the past year?  Do you perform root cause analysis on significant variances?

I like to have my exit planning clients review the two graphs below.  Both graphs produce essentially the same average gross margin over the 12 months.  Then I ask my clients, if they had to choose between purchasing Company A or Company B, which would they select?  This frequently is when the light goes on.

Two company gross margin comparison showing wide variance in company B and small variance in company A, yet both have the same average gross margin.

Invariably clients select Company A over Company B for obvious reasons when they see how cost of goods can sink your exit plan.  Then we look at their gross margin trend and develop an action plan to fix the business processes that are creating variability in their cost of goods expense.  If your business’s gross margin trends look more like Company B than Company A, contact me today to learn how you can stabilize business performance and extract the company value you have worked so hard to build.

If you are a business owner that is looking for ways to improve the salability of your business, please contact us today

About the Author
About the Author
Chase Morrison  provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.

 

How to value a business is a complicated questions, but it is not a game of chance.

What is my Business WORTH?


How to Value a Business is a Complicated Question

This is a common question asked by our clients and prospects.  Now that so many Baby Boomer business owners are more seriously contemplating their succession plan options, how to value a business is coming more to the fore.  The first thing to understand is that a business can have a wide range of values depending upon the how a business owner decides to exit their business.  Though there are many options, for now we are going to focus on valuing businesses from the perspective of a buyer.

If you want to learn how to value a business, here are some of the basics. Though there are many approaches remember that buyers are looking for cash flow. Click to Tweet

What is EBITDA?

Even though we are going to approach business valuation assuming that you want to sell your business, only a professional valuation expert can give you a truly accurate valuation on your business.  But for simplicity we have narrowed the range of exit options to a sale.  So what do potential acquirers care about?  At the most fundamental, potential buyers care about–current and future cash flows. 

To get a handle on cash flow, a potential buyer will try to estimate free cash flow using a metric called Earnings Before Interest, Taxes, Depreciation, and Amortization, which is also known as EBITDA (commonly pronounced “ee-bit-dah”).  This is a straightforward computation that adds back Interest Expense (and subtracts Interest Income), Tax Expense, Depreciation and Amortization to your net income.  Why adjust for these items you may wonder.  Depreciation and Amortization are non-cash expenses and are always added back to cash flow.  Interest and Taxes can be rather variable depending on the current business use of debt, and other tax-related factors and are eliminated from net income to produce a “normalized” free cash flow. 

How are Multiples of EBITDA Used?

With an estimated EBITDA in hand, a potential acquire can compare the cash flow potential of different businesses to identify acquisition targets.  Generally, businesses are valued in multiples of EBITDA that are adjusted for a number of factors.  As a multiple increases, so does business value.  So a business with $1M of EBITDA and a multiple of 4x, could be valued at $4M.  Multiples represent the potential return an acquirer needs to move forward with an acquisition.  You can compute the acquirer’s return by taking the reciprocal of the multiple.  In our example above, a multiple of 4x equates to a 25% return (1/4x = 25%).  A multiple of 3x equates to a 33% return, and so on and so forth.  Multiples for privately held businesses typically range from 2x to 11x.

What Kind of Multiple to Expect

You are probably wondering what factors control the multiple for privately businesses given that the expected return ranges from 50% (2x) to 9% (11x).  The first and foremost is the lack of an open market to buy and sell privately held businesses.  If there was a liquid market for privately held businesses, then multiples would be higher.  The relative illiquidity of the market for privately held business increases return levels just like coupon rates increase and decrease based on the quality of different bonds.  The next level of factors pertain to business size and industry.  The greater the business size, the greater the multiple.  And as you can imagine, businesses in certain industries are in greater demand than others.

How to Influence Your EBITDA

The next set of factors are the ones that a business owner, can influence.  Though they require varying amounts of time, there are many items a business owner can affect to increase their business multiple.  The first and foremost is revenue growth.  Are you able to grow revenue?  A decreasing revenue trend will be a significant red flag for potential acquirers.  Next, have you established protection around your intellectual property?  Do you have trademarks?  Are they registered?  How about your logo, is it registered?  Have you had your CPA firm review your financial statements recently?  Do you have reviewed financial statements?  How do your financial metrics for profitability and working capital use compare to your industry cohort?  Are your IT systems current with the latest technology for security and speed?  Does your company have outstanding litigation with other companies and/or employees that needs to be resolved? 

Think about the types of things that a prudent acquirer would try to uncover during due diligence and work to resolve any obvious or latent risk items that can impact price well ahead of time.  Frequently business owners spend little time getting into these details only to have the acquirer demand price concessions at close, for items that surfaced during due diligence. 

Lastly, the most important way you can influence your multiple is to build a team to help you with the process.  Many business owners become distracted from their typical day-to-day sales and marketing activities need to maintain/grow the top line, which can have disastrous effects the value of a company.  As a CFO services firm, we help business owners build a team, address how to value business and much more.

About the Author
About the Author
Chase Morrison provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.