Your business has grown and you now find yourself in a precarious situation: you don’t have the proper financial procedures to efficiently and effectively manage your newly found success. You are not alone! There is no reason to feel bad about it, most entrepreneurs primary focus is cash flow, not diligently structuring their books and records. As long as there is enough money in the company’s bank account, employees and bills are getting paid, everyone is happy. Then the day comes when you need to obtain financing for a new piece of equipment, but it takes forever to gather the necessary documents and underwriting keeps rejecting your profile. If only you had known then what underwriting would be looking for and had taken the necessary steps to maximize the value of your business. Let’s look at two critical items that can dramatically affect the value of your business: cost of goods sold (COGS) and accounts receivable (AR).
To begin with, it’s important to understand that your financials and procedures can (and will) directly affect the valuation of your business. Of course there are many variables that make up your valuation (recent M&A transactions, contracts, reserves, leverage, growth rate, etc.) but COGS and AR are the two items that can directly impact your final number in nearly all valuation models used in investment banking. Taking things a step further, the name of the game in this area of business is preparation. Being ready to obtain financing or transact a sale is imperative to building a robust and successful enterprise. As the leader of your business, one of the key elements to success is anticipating the next move in your market. Having access to capital for an acquisition to grow the moment an opportunity arises can be a game changer.
Let’s take a closer look at the first item, cost of goods sold (COGS). Depending on the valuation method used, COGS plays an exponential role in the calculation and even a difference of a few basis points will directly impact the value of your business in a big way. As you may know, COGS is typically calculated using either cash or accrual based accounting. The less preferred, cash based accounting is a simpler but less commonly used method and can create complications as it can theoretically compare the cost of yesterday’s inventory with today’s pricing. Though more complicated to record and track, accrual accounting provides a clearer picture for underwriters and acquirers to analyze how funds flow through your business and allows revenue and expenses to be more closely matched.
The second item you’ll want to review is your accounts receivable (AR). It plays an important role in determining the overall health of your business. The customers that are paying and not paying, in addition to the aging of your AR are only a few of the items that will be analyzed when your financials are under review. Being able to provide detailing for your current AR can make a big difference when it’s time to substantiate your valuation.
Every business sector has their own common methodology for calculating value. Depending on your specific sector and timing, the majority of precedent transactions will rely heavily on one or a combination of different methods. In nearly all methods however, COGS and AR will be used. As a result, fine tuning these pieces can impact your value in a big way when it’s time to apply for credit or engage in an M&A transaction. Many big businesses rely on employees or subcontractors to ensure their business finances are properly managed. If your company does not currently employ these specialists, you may want to consider consulting an outside agency well before your anticipated liquidity event. Many investment banks specialize in providing services of this type.