Valuations and depreciation

Ask a business broker to place a value on your business and 99% of them will exclude depreciation and interest expenses from net operating expenses, and as a consequence they will often arrive at a significantly higher valuation than what Larry Hunt and I would arrive at using our business valuation methods.

Why? Because we view depreciation as a real expense to be considered, not a purely hypothetical $$$ amount that can be casually added back to net profits and translated into an increased valuation of the business. Why do brokers do this? First, it often leads to a higher valuation and a higher valuation always pleases the seller and brokers almost always represent the seller.

If you purchase a $100,000 piece of equipment and depreciate it over five years (straight line) then your Profit and Loss statement will report a depreciation expense of $20,000 each year. Most brokers will add that $20,000 back to cash flow when attempting a valuation. We, on the other hand, will treat it as a legitimate expense, even though a check was never written in that year.

On the other hand, suppose at the end of the year you decide the purchase was a terrible idea and you call the dealer or run an ad in a trade magazine. What do you think that piece of equipment will sell for at the end of the year? Do you think you can recover 80% or $80,000? Chances are good that you will be very lucky to recover even $80,000. Most likely you will be offered less. Whatever the offer, I think we most of us can agree that we will get significantly less than we paid for it and it is the difference between selling price and current value that depreciation is supposed to represent. When you sell an asset for less than you paid for it that is depreciation and that is exactly what you end up doing when you sell the business... you end up selling earnings potential and the assets used to produce those earnings.

What happens if you depreciate that piece of equipment over a five-year period of time. What do your financial statements look like in the sixth year? Well, assuming that piece of equipment was the only purchase in the past five years, your financial statements are no longer reporting a depreiation expense and your balance sheet shows an asset value of $0! In "Print Shop for Sale" we would assign a real-world, market value to that asset since it no doubt has some residual value while at the same time continuing to produce earnings for the company.

More on this topic later.

High Payroll Costs Killing Three Firms!

In less than six weeks I have consulted for three firms, ranging in sales from $400,000 to $1.6 million and in all three cases the numbers were nothing short of shocking.

One company had allowed its payroll to skyrocket to more than 41%. With typical COG running at an average 26-30% and general overhead expenses running in the mid 30's, this company was bleeding "red" ink.

Shockingly, the owner had never really isolated his direct and indirect labor costs. He simply didn't know what to look for and needed prodding just to take the first step.

What was the first step? Terminate at least 3 employees in the next 48 hours. He did that. Another employee gave the owner her notice about a week later. Her notice had nothing to do with the turmoil at the company. What are the prospects that this company will survive another six months? Probably less than 50-50.

Another company in the midwest had labor costs at 37.6%. Once again, when you see a number like that you ought to react immediately, and not sit back and wonder how much more sales need to increase to bring that number back in line. It really can't be done. Don't delude yourself.

NOTE that is cases where Payroll Expenses are cited, they should not include wages, salaries and benefits paid on behalf of the owner.

My third company is doing a bit better, and has a bit more breathing room, but even this company is in serious troubles with payroll costs above 32%.

By the way, two out of the three companies mentioned above have clearly been violating FLSA (Fair Labor Standards Act) regulations by placing one or more employees on salary and expecting the employees to work "whatever hours are necessary" to get the job done. In one of these cases, the owner has already been fined and is looking at an audit that will cost him $1,000's of dollars in time reviewing payroll records for hundreds of employees going back more than four years.

Anyone who thinks you can simply place someone on an annual salary and thus be exempt from paying overtime is most likely a fool. I couldn't say stuff like that on list servs I formerly belonged to, but I sure as hell can say it here. You are playing with fire when you place anyone on a salary and assume that they are exempt from overtime regulations.

I spent more than 30 minutes today with an owner who was trying to find some loophole that would justify keeping one employee on salary.

By the way, the audit mentioned above - how was it initiated? By one former employee who decided to make a formal complaint with the local wage and hour board. That's all it took to get the ball rolling, and once it started rolling it just got bigger and bigger!

Wage Freeze & Reduction in Benefits

A reader just commented on my previous post, by asking, "John, what about a wage freeze or benefit cuts? We are seeing again this year a double digit increase in health and pay 75% of that cost. I am looking at not keeping during our slow time, one employee and cutting back to 35 hours the rest of my staff or giving raises to spring or summer."

I believe that either one or both of the first two alternatives (a pay freeze or cut in benefits) are preferable to a reduction in salary. I see nothing wrong whatsoever with freezing wages until some time in 2010. As for cutting benefits, such as selecting a new health insurance program with higher deductibles, I have no major problem with that approach either.

However, I disagree with the "cutting back to 35 hours" because once again you are asking everyone to suffer by instituting a 12% cut in their salaries. Sure, cutting hours back to 35 is better than a reduction in hourly pay, but the net result is the same, a reduction in take-home pay.

Sure, the employees are working fewer hours, but just as important, if not more so, is the fact that their real-world take-home pay is being reduced as well. Most employees live from week to week and paycheck to paycheck and in this scenario everyone will feel the pain.

A better solution (in my opinion) is to terminate one employee as opposed to reducing the take-home pay of all employees. Granted these decisions are not easy to make. Terminating an employee is much more painful for both the employer and the employee who is terminated.

Then again, no one ever said running a small business is supposed to be easy.

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Reducing Wages vs. Terminating Employees

The subject of whether you should reduce wages (i.e. lower the hourly rate for all employees by a specific percent) as opposed to terminating an employee has come up on two or three occasions in the past couple of months.

In one case specifically, a former client told me how much she was sacrificing to save her business and she had instituted an across-the-board pay reduction of 15%. In another case an owner asked me in advance what I thought he should do, reduce payroll or terminate employees.

I am emphatic that you should never penalize an employee team by exacting from them something they previously earned. If business slows down dramatically, it is your responsibility to lead the company by making hard decisions, and in my opinion reducing hourly rates in order to assure that everyone keeps their job is not the way to do it!

Most owners are exposed to the idea of reducing hourly rates across-the-board from listening to the evening news and hearing stories about trade unions agreeing to accept a cut in pay. Think about it, from the employee's standpoint and even more so from the union's standpoint, that is a smart move. The employees love the union for saving their jobs and they hate the employer for reducing their wages. The union finds itself in a win-win situation. The bottom line is what works for larger corporations and unions does not work for small businesses.

If you have a team of seven employees and their total annual payroll is $237,120 and you decide to reduce their payroll by 15%, that will lead to an annual savings of approximately $35,568.

Every single employee will be affected by this pay cut and every single employee will suffer. Worse, the pay cut will probably be accompanied by a speech by you that says something to the effect, "Folks, we are going to have to work harder than ever before as a team and I expect everyone to pitch in during these challenging times."

No matter how hard you try and no matter how sincerely you make your case, they will not believe you, even if you tell them you too are taking a paycut, or haven't received a paycheck in three months.

What will happen is that seven employees will be disgruntled by the suggestion that they should continue to work just as hard but work for 15% less pay than they received before. Every single employee will feel this way, no matter what you say or do.

My strong suggestion is that you thoroughly examine you list of employees, calculate your SPE which is probably lower than it should be, and then terminate the least productive of the team. In a real-world scenario involving seven employees with hourly wages ranging from $20 per hour down to $12 per hour, the reduction of virtually any single employee (but for the lowest paid) will accomplish the same $$$ savings that you would have accomplished from a 15% pay cut across-the-board.

Told of the options you faced after you have made the decision, the remaining employees are far more likely to respond to a pep talk than a speech announcing a 15% pay cut across the board.

A pay-cut embitters all employees, while a termination impacts only one.

A pay-cut will most definitely negatively impact the morale of the entire company, forcing many of the better employees to start looking for other jobs. A termination of one employee, on the other hand, will clearly convey to the remaining employees how serious you are and the steps you are prepared to take in order keep the company going.

By the way, don't be surprised, especially if you terminate the "right" employee, that one or more employees come up to you later and gently chide you that you should have made that move much earlier.

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Things You Absolutely Cannot Do...

A recent consulting assignment was one of the most challenging I have ever tackled... $1.2 million in annual sales and was/is bleeding to death... The full story will have to wait for a week or two, but some lessons learned can be shared now.

Never, never loan your company money without a specific, documented plan for repayment. The only worse thing you can do is make another loan to supplement the first. If your company owes you money (check your balance sheet) and your cash flow is low or non-existent, make installment payments to yourself in lieu of taking a salary. You will save on payroll taxes and improve your balance sheet.

Never, never fool yourself that you can survive with an SPE below $100,000. The chances are good that unless you take immediate steps to improve productivity (and your SPE), that your SPE will drop rather than improve.

Never, never allow your total payroll to rise above 30%! There is no way a company with payroll costs at or above 30% will survive in the long-run. Don't lie to yourself and your spouse that things will get better. They won't so long as you ignore this number.

Never, never ignore your financial statements - The most troubled companies I have encountered these past three years are those that either don't receive financial statements on a regular basis, or if they do they never read them and compare them to the readily available ratios that can point the way towards survival and turn-around. If you want more information about some of these key ratios check out my recent blog that discusses "the six pack" of flying instruments.... (or something like that. )

It's late at night and I wish I could share more of my thoughts, but I spent 18 hours visiting with this firm and at least another 18 hours trying to pull my thoughts together and recommend step-by-step measures that might, just might save this company.

There's one very special problem I encountered with this consulting visit, but I could not bring myself to tell the client and I am still trying to determine whether it should be mentioned. I may share this in a future blog.

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Break-Even Analysis Spreadsheet

You can now download an easy-to-use Excel Spreadsheet that allows you to play various "what-if" Break-Even scenarios.

All you need is a current set of financial statements, from which you will be able to extract your total fixed overhead expenses, your cost of goods as a percent of sales, and your payroll figures, extracted either as a fixed dollar amount or as a ratio.

To download, click the link in the navigation bar above or go to: www:quickconsultant.com and follow the "download" link to find the Break-Even spreadsheet.

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Throwing in the Towel & Breakeven Analysis

You wake up suddenly one morning and realize that your business is going under, and going under fast. What do you do? In some cases, owners become overwhelmed with current debt and in the end they are left with few if any options other than to throw in the towel. If they are lucky, they get to file for Chapter 11 or reorganization, but that is typically so expensive that only the lawyers win in that situation.

In a few cases, calculating your breakeven and then playing "what if'" games with the key ratios might help shed some light on your current perilous situation and it might suggest specific steps you can take to avoid bankruptcy.

Breakeven calculations are designed to estimate the current monthly (or annual) sales required in order to satisfy all of the company's monthly fixed and variable expenses. If your financial statements are properly organized, you should be able to conduct this analysis quickly.

(To download a sample of the Excel Spreadsheet go to my downloads Page)

Cost of goods (and those items listed beneath this heading) are almost always considered variable and are directly expressed as a percent of sales. You need to know what your current COG ratio is in order to calculate breakeven.

What about Overhead Expenses? Generally speaking, overhead expenses are considered fixed, and are usually expressed in raw dollars each month required to cover advertising, accounting, rent, etc. From a practical standpoint, you would not include depreciation as a monthly expense, BUT you would include all interest and note & loan payments, which would normally be found on your balance sheet.

What about payroll - is payroll treated as a variable (thus a percent) or do we treat it as a fixed expense, and thus as specific dollars required each month? I suggest treating it as a variable expense., because that is what it should be.

You need to know what your total current payroll ratio is, including all related payroll expenses such as taxes, fica, workman's comp, etc. Do you include a basic salary for yourself as well? Well, that depends upon the purpose of preparing this breakeven analysis. If you are trying to calculate the bare minimum montly sales required to pay all the bills but before you take out a salary then leave your salary out of the ratio. If, on the other hand, you require at least $3,000 per month to cover living expenses then make sure that $3,000 is included in your payroll percentage.

Here is a practical example of a real world company facing a crisis. This company is currently averaging $100,000 in monthly sales.

Monthly overhead costs (fixed) are $52,000 which includes $23,000 per month in loan and note payments. Monthly COG is running 25% which is excellent.

Monthly payroll, however, is terrible at 38%. So let's figure the breakeven sales for this company required to meet all of its fixed and variable expenses.

The basic formula is: Fixed Costs ($) + (Variable Costs * BE) = Breakeven (BE)

To solve the above, divide total Fixed Costs by (1-variable costs) to calculate Breakeven.

Note Payroll is 38% and COG is 25% for a total of 63%. Using our formula, we have the following:

$52,000/(1-.63) = $140,540

Note the breakeven is well above current sales level, and the company is losing buckets of money each month.

What happens if overhead $$$ remains the same, and COG remains at 25%, but we trim payroll costs from 38% to 28%? Let's re-figure:

$52,000/(1-.53) = $110,638

With that single change (not a painless one, but possible) this company only has to increase sales by $10,000 a month to meet all of its monthly obligations.

Now, recalculate again, and find a place to trim just $4,000 from overhead costs and the breakeven drops to $102,000.

Raise prices by 5% across the board and that automatically lowers the monthly COG by 1.2%, and a new breakeven for this company becomes $99,585.... In fact, the company might actually start producing a very modest profit with these new ratios.

Yes, I've thrown a lot of numbers around above, but a breakeven spreadsheet is easy to prepare and can be very useful for calculating the impact on future profits and sales when various changes are made to certain fixed and variable expenses. I will try, in the next day or two, to post a simple spreadsheet where you can plug-in your own numbers to see the impact of various changes on your overall profitability.

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Keeping Your Ratios in the Green

A couple of blogs ago, I discussed the "Six Pack" of instruments used by pilots. Monitor and scan those instruments frequently, and a pilot is likely to have a safe flight. The same is true for our "Six Pack" of key ratios in the small format printing and digital copying arena.

Pilots often are told to make sure their instruments are reading in the green, and the same should be true for the instruments we use to run our printing and copying businesses. Below are are the specific numbers you will need to look for to keep your instruments in the green. How do your numbers compare?

1. Profit & Loss Statements - To remain in the green, you must receive financial statements on a monthly basis. Nothing else will do. Even more important is that you must take 15-20 minutes studying these statements and comparing them to previous statements, taking note as to what trends (good or bad) are developing.

2. Payroll Costs as a Percent of Sales - You must keep total payroll costs at or below 29% to remain in the green. As soon as you see this ratio rise to 30% or above you need to carefully examine possible trends that may be developing in your company. You are clearly entering the yellow or orange zone (if not the red zone) if your payroll costs rise to 31-34% or higher.

3. Paper Costs - Paper Costs as a percent of sales should rarely if ever exceed 11-12% if you want to remain in the green zone. Let this ratio climb by even one percent and it is an early sign of trouble ahead. Companies reporting a signficant percent of their sales coming from digital copying often report total paper costs in the 9-10% range.

4. Sales Per Employee - In order to remain in the green, I believe you must maintain or acheive an SPE of at least $125,000. That isn't a great number and certainly doesn't represent the best that can be achieved, but it should be enough to keep you out of trouble.

5. The Current Ratio - Too many printers ignore their Balance Sheet because it sometimes doesn't make a lot of sense. The current ratio rarely appears on you balance sheet but it can be calculated quickly by dividing your total "Current Assets" by total "Current Liabilities." Make sure the entries for both these categories are properly recorded. To remain in the green, nothing less than 1.7:1 should be permitted. Even that is a bit weak, but it would still be in the green. Below that number, and you are drifting into the yellow, orange or red zones - zones you definitely want to avoid.

6. Owner's Compensation - An owner's compensation of 13% will barely keep you in the green, but you won't have the safety margin you need to move forward and grow your business. Ideally, you need to be striving for an owner's comp of 17-20%, which is a level that 25-35% of our industry achieves each year.

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