Over the years, I have spoken to many financial planners, concerning both my own future and that of clients. The routine has always been the same, “What assets do you have, how much is in your Super fund, and how much ready cash have you invested?” Never once was it suggested, “May we have a look at your business history?” Our business is the best long-term asset we have!
For many years perhaps this really didn’t matter, however, with the evolution of a global economy, Australian companies are finding it more and more difficult to compete and to make reasonable profits. Unfortunately, far too many business owners out there still adopt the “I’ll be right mate!” attitude. It would therefore be a great help if we can get different people to hammer home the importance of solid management practices, as the accountants are already perceived as a ‘nagging bunch’.
Financial Planners in today’s economic times have never been better placed to play an important part in enhancing better management practices.
This article is written with the hope that more financial planners will become involved in the value adding process of financial planning, and by doing so offer a point of difference in the services they offer.
I am not suggesting that you play an accountants role, or expose yourselves to any additional liabilities, but to use some tools and benchmarks to use for discussion with clients. This will inevitably give them some sensible ‘food for thought,’ as well as developing a clearer direction to enable them to move forward.
The bottom line is who would result in a better client, one who has $200,000 to invest or one that has $2,000,000 to invest?
It is assumed that the readership are well acquainted with all the issues surrounding financial planning, such as statutory requirements, tax laws, etc, so this article does not address any of those issues.
This model is currently the best model to use, as the ‘baby boomer’ segment of our society will be retiring progressively over the next 15 years and a large percentage are business owners.
When people think about building a business as a retirement vehicle, they have a few options:
The choices people make will depend on individual circumstances, so only a fool would second-guess what is the best solution. What we can do, however, is to point out potential pitfalls for each case.
Most business owners dream of the day they get paid millions for their company. This, however, rarely happens, so some obvious questions are;
This sounds like a sensible idea on the surface, however, there are some questions to consider;
This too appears to be a good future strategy, however, some potential issues to consider are;
These issues will be looked at more closely later.
This is a question that will vary with every individual, so there is a good tool to use, which takes into account individual needs.
Table 1
Table 1 gives a simple example of how much money a couple may need on retirement. We have assumed here that they have little or no assets, investments, shares or superannuation on retirement. Obviously, any assets will be factored into the equation. We do have a separate tool for that purpose. We are deliberately keeping this basic, for simplicity of explanation.
From Table 1 it is already interesting to see how much money is required, should the couple both live for 20 years after retirement!
This, however, is by no means the end of the analysis. If someone is building a company to fund retirement, then we need to use the required sum of money as shown in Table 1 ($4,633,244) and extrapolate that into a business environment.
Table 2
In order to achieve the target amount of cash in Table 1, Table 2 calculates what we need in terms of ‘Simple’ Sales on average per year, depending on how long we want to wait to retire, to achieve our cash objective. Table 2 calculates sales assuming a 15% profit after tax.
A profit of 15% after tax is the exception rather than the rule in the commercial reality of being in business. Most companies have a profit less than 15%. We will now do the same calculations on the average profit companies achieve.
Table 3
Table 3 looks a bit ‘ugly’! Here we have calculated Sales based on 5% Profit after Tax. This is, however, the average profit percentage achieved in the current business environment. If Profit is less than 5%, well then it all seems to be a waste of time. The Government old age pension starts looking more attractive at this point!
Unfortunately, the picture gets worse! The Tables 2 and 3 have been called ‘simple’ profit plans because in reality, not all the profit is ‘bankable’. Bankable being that not all the profit may be taken out of the business as cash. Some very good reasons for this are;
We will now look at the calculations, assuming some cash stays in the business.
Table 4
Table 4 demonstrates that we need two and half times more sales than in Table 2 ( for retirees in 5 years) if the retirement target is to be achieved when 40% of profit is retained in the company. This level of Sales is certainly possible to achieve, for companies that have been around for many years and have been well managed. For anyone thinking of a start-up company and achieving these sorts of figures is not impossible,but highly unlikely. Once again, we will examine this same scenario for a company whose profit is 5% of sales.
Table 5
Table 5 calculates the sales required in the same way as Table 4, however, the profit in this case is 5% of sales. This is now becoming a pipe dream, rather than reality!
What then does this all mean to Financial Planners?
This simple analysis demonstrated to clients serves as a ‘shock’ mechanism. It certainly gets a clients attention and helps to get clients serious about planning for retirement. These examples serve only as tools for Financial Planners to use as an introduction to new and existing clients when trying to create a point of difference.
The fact is of course that in reality, the assets, superannuation etc would be taken into account, making the retirement value considerably less, but the process of analysis remains exactly the same as has been demonstrated so far.
This particular tool enables financial planners to work with clients to set an achievable goal for retirement, without actually giving them professional business advice!
There are not too many business owners or company executives, who really understand the relationship between profit and sales. There are two facets to the relationship between profit and sales;
Examples of this are better demonstrated graphically:
Graph 1
In Graph 1 by using the profit as a value, it appears that, apart from Year 5, the profit is trending up! In numerical terms it is, however, let us now look at the same graph, except we will compare sales with percentage profit
Graph 2
Graph 2 presents a completely different picture. The percentage profit is trending down over the entire 5 year period. It is hardly surprising that this company ended up in a loss situation in Year 5.
The problem with profit trending down, particularly when it is below 10%, is that the company starts to run short of cash. Invariably, they then borrow money, which compounds the problem, as all the interest, fees etc, contribute to more costs, and what’s worse it becomes a fixed cost! The higher the fixed costs, the less options managers have to implement more efficient processes in the variable components of the company.
The message in all of this is, beware of executives who grow sales at the expense of profit. In this case the company has definitely been guilty of sales growth at the expense of profit. Don’t forget, they are building the company for retirement!
What we have covered so far emphasises the need for good profits, in any case where company owners wish to build the business for retirement.
This is particularly relevant in cases where the intention is to ‘milk’ the company of cash for future retirement and for cases where succession planning is the goal for ongoing income.
It is also potentially true for executives who wish to sell the company for funding retirement, however, there is a lot more involved than just profit.
Graph 3
Graph 3 is a useful tool to demonstrate to executive clients, how much more difficult it is to reach retirement goals with low profitability.
This methodology can also be used in cases where executives own shares and/or receive sizable performance based bonuses in exactly the same way as demonstrated in this article. The dividends paid, combined with the bonuses, are what would be of particular immediate interest to financial planners in building wealth for future retirement. The longer-term interest is in what the shares may be worth on retirement, what the likely fully franked dividends may look like in the future etc.
It is essential, however, to deal with what is real in the immediate future, and to lock that away for retirement. The long term aspects, whilst important, can’t always be relied on in the medium to long term.
Many people seem to think that profitability is the only factor that influences the value of a company and its attractiveness to a buyer. Profit is important, however, what buyers usually look for is how they can leverage the purchased company into increasing the return on their owners’ equity to a rate higher then they are currently achieving. What they don’t want to buy is a history of poor debtor management, poor stock turns, redundant assets etc. If they still want to buy a company suffering those cancers, then you can be assured that the price will come down significantly.
As a financial planner, then what role could you play here, without trying to offer business advice?
By developing a few simple tools, you as the financial planner could add a significant amount of value to clients by ‘steering’ them in the right direction.
We will now look at what buyers would be looking at in their due diligence process before deciding on a purchase and a price they would be willing to pay.
Table 6
Table 6 represents a simplified profit and loss statement, and compares two companies in the same industry, with the same sales.
The important segment of this profit and loss is the ‘cost of sales’. This is where they will get most leverage.
The ‘operating expenses’ are often not considered particularly relevant, as if they purchased the company then in most cases, a large percentage of the operating expenses will be absorbed into their own structure. With this in mind it is likely that most of the ‘rationalisation’ in terms of job security will affect the operating expenses area.
Comparing the two companies ‘cost of sales’ now, the first line that attracts attention is that of direct labour. Company B clearly does not manage its direct labour as well as company A. Company B spend a lot more money, than company A on direct labour to generate the same sales!
Cost of goods sold is also a problem with company B. The reason is simply that either they don’t purchase very well, or that their mark-up is too low, or a combination of both.
The same problem exists with ‘external costs’ as with ‘cost of goods sold’
Once we look at overheads, it is now apparent that Company B is poorly managed and in most cases, a buyer will look no further. If they do it will only be to get a real rock bottom bargain, in other words for a substantially lower price.
Company A, at this point looks like a good prospect as the figures all match up to good commercial benchmarks, particularly profitability. These, however, are not the only factors of interest to a buyer.
In either case, Company A or B if the decision is to continue investigating the possibility of purchasing one of these companies, the next step will be to look at the balance sheet.
Table 7
Examining Table 7, the areas that would be of concern to a buyer for company B would be;
How did we arrive at those assumptions, and why are we assuming Company A stacks up well. It sure does against Company B, however, is company A’s balance sheet what a buyer would be interested in purchasing?
A very good question.
We will now look at some important ratios, which will make the task of deciding whether or not to purchase and at what price, far less onerous.
Table 8
Table 8 is a summary of the important criteria a buyer would look at in determining whether to make an offer. Company A has been deliberately tailored to give financial planners benchmarks on what clients should achieve for their companies, building for retirement.
The tan segment represents profit and loss ratios, the aquamarine segment represents balance sheet ratios and the uncoloured segment will be discussed later.
What the balance sheet ratios mean; (We will refer to Company A’s ratios for the explanations)
When comparing company A with company B the only area where company B scores better than company A is with Asset Turnover. The problem is that Company B has fewer current assets than company A because of their negative cash position, which has affected the Asset turnover ratio.
At this point, most potential buyers would bail out of company B as even at a bargain price there are too many problems with the company, most of all with its management!
There is one aspect yet to look at, and that is the relationship between fixed and variable costs.
To perform a break even analysis all the costs in the P&L need to be divided into Fixed costs( those costs that don’t vary with sales variations) and Variable costs (those costs that vary with sales variations). This exercise is best left to the accountants.
There are two important factors to look at with a break even analysis;
Table 9
From Table 9 it is evident that company A needs to sell less to make a profit than company B and company A has lower fixed costs than company B.
Before continuing, it would be useful to look at what the break even point is for both companies.
Graph 4
Graph 5
From Graph 4, company A only needs to reach sales of 600,000 before they start making a profit.
Company B (Graph 5) on the other hand has to reach sales of over 900,000 just to cover costs.! Company A at the same sales point has already made almost 200,000 profit!
Why is keeping fixed costs low so important? As a guide fixed costs should be around 20% to 25% of sales.
The reason for this is simply that;
Succession planning is most often a family situation, usually when the children are old enough and experienced enough to take over the reigns, so to speak.
Be warned that this scenario is usually emotionally based rather than commercially based and is fraught with potential problems;
If a client is insistent that this is the way they are going, try to persuade them to;
Financial planning has always been an important component of our economy, but it has never been more important than it is now. The retirement exodus we are likely to see over the next 10 to 15 years is the very platform smart financial planners will use to bolster their own retirement plans!