Every now and then I think back to when I was taking accounting courses at University, occasionally my mind recalls the five goals of an organization. Actually, I generally remember four of them; stability, liquidity, profitability and growth but for the longest time couldn’t recall the fifth. Then, finally one day completely out of the blue it came back to me, equity.
The reason I have not forgotten these is because, back then and still to this day, it surprises me that among the goals of an organization, nowhere to be found is service to the customer. I would have thought that that would be among the top goals of an organization – but that’s another story.
The other day, not too long ago, another a stroke of genius (I get the odd one) hit me. The five goals of a business (stability, liquidity, profitability, equity and growth) clearly define what buyers of businesses, whether consciously or intuitively, are looking for. Whether they know it or not, buyers of businesses are looking to see how stable, liquid and profitable a business is, how much equity it has, and how it has been growing. Let’s look at each one in a bit more depth.
Stability is important to a business because it is the foundation upon which you build. A stable business is worth more because the potential buyer knows that they are more able to rely on future sales meeting or exceeding past sales. Some of the tests of stability are;
Sales volume. Does it go up and down like the tide or is it more stable, growing slowly and steadily? Is it growing or declining?
Number of customers. Are sales dependent upon a small group of clientele or are sales widely distributed amongst many clients? While a small group of loyal clients is a good thing, the loss of only one client can spell big trouble.
Number of product offerings. While only selling a small basket of products makes for much easier inventory handling, it puts the business at a much higher risk if one or two of those products become subject to new competition.
Profitability. Does profit vary widely from year to year or is it stable?
While it is desirable and a good sign to have a high dollar value of assets, it is more important that those assets be liquid, or to put it in plain English, easily disposable.
A produce business is probably the prime example of a non-liquid business. If anything were to happen that the proprietor had to sell his business, he is in big trouble. Produce has a very limited shelf life and if he doesn’t find a very interested buyer immediately, the value of his inventory drops rapidly. Even if he did find a buyer right away, that buyer will understand the situation the seller is in, and will likely start out with a very low offer.
At the other end of the spectrum are things like gold and mouse traps. The simple 99 cent mouse trap hasn’t changed in a hundred years and isn’t likely to change any time soon. If a proprietor had to sell her business or dispose of her mouse traps, she could put them into storage and shop for a serious buyer; they aren’t going to go bad.
Profitability is arguably the most important of the five goals of an organization. If a business is profitable, it is referred to as a “going concern” or a business that can pay its bills and pay the owner a living wage. As I briefly alluded to earlier in the Stability section, profits that are stable and predictable from year to year are more valuable than profits that fluctuate wildly.
A very good example of the importance of profitability is the hotel/motel industry. Their profits can vary significantly with economic change and so does the resultant value of the business, even though the underlying brick and mortar assets have not changed. In small businesses, we often use a multiplier of “Owner’s discretionary earnings” to value the business. This multiplier varies between 1 and 5 times earnings, with 2-3 being most common.
Now before you go calculating the worth of your business, it isn’t that easy. Many items have to be taken out of, or added back into your income statement to arrive at an accurate number for “Owner’s discretionary earnings”. For example, all those lunches at McDonalds that you claimed as a business expense, well, aren’t. As another example, did you take a depreciationexpense? Basically, the financial statements need to be gone over with a discerning eye to ensure they meet or at least reasonably meet what is called GAAP or Generally Accepted Accounting Principles.
Remember a few years back when a number of large organizations got caught redhanded cooking their books? Do you remember how many other large “respectable” organizations came out and “re-stated” their earnings after that? There were a lot of organizations playing fast and loose with GAAP.
Equity is simply a representation of how much money you would theoretically have left over if you sold all your assets and paid all your bills. When determining equity, it is assumed that you will receive this elusive thing called “market value” for your assets. Market value is how much money a willing seller would receive if he found a willing buyer, given a reasonable amount of time to expose the property to the market. Equity tells us a few things. If you are showing high profitability every year but the business has very little equity, then either you are pulling out all your profits and spending them, or you are one of the companies that were playing fast and loose with GAAP – in other words, you’re fibbing.
A business could also show high equity if no depreciation was taken for the tangible assets (let’s say a car for example), but even if you don’t account for the depreciation, the asset (a car, for example) has depreciated and is worth less than what your books say. So, equity is another number that is often not as it seems on the surface. Some digging is generally required to get to the bottom of things.
And finally we come to growth. A growing business is always a good thing. Growth shows demand, and particularly, growing demand. A business in demand is likely to be around a lot longer than one with flat or falling sales. And, you guessed it, growth – like everything else we’ve discussed so far – is not always as it seems.
How does the growth of the company compare to the growth of the industry as a whole? If your donut shop is growing at 12% per year but the donut industry as a whole is growing at 16% per year, you are in actuality falling behind the rest of the industry.
What was the economy like during the period under review? If the economy was faltering but your sales stayed the same, your business has actually grown in comparison to the rest of the economy.
So there you have it, the five goals of an organization and how they coincidentally (or not so coincidentally) relate to the value of the business when it comes time to sell or buy. These five factors are far more in-depth than can be adequately covered in a 100 page document, let alone a blog post – but hopefully this gives you some insight into what you should be looking for as a seller or buyer of a business.
Unfortunately, at the end of the day, most businesses have a market value somewhat less than the proprietors would like to get and somewhat more than what a buyer would like to pay… so, nothing new I guess.
Written by Gerald Tostowaryk, FRI
Gerald has been a licensed real estate agent in the Edmonton area since 1991. He initially sold residential real estate and transferred into the commercial sales and leasing field in 2003. He was an active instructor for the Alberta Real Estate Association for approximately 15 years. Gerald has served on numerous boards and committees, including the REIC Edmonton Chapter Board