CHAPTER 11

Using Financial Information to Gauge Enduring Profitability

In this chapter, we will show you how to look at several financial measures of a business to quantitatively filter your prospects for enduring profitability. Most businesses, even small ones, keep accounting records that can be used to inform these calculations and measures; these should be provided to you after you sign a nondisclosure agreement with the broker or owner. Sometimes this information is kept by a bookkeeper, sometimes by the owner, and sometimes by a professional accountant. For now, assume that the financial information is collected accurately; we’ll talk more about how to verify this in chapter 14, “How Much Should You Pay for a Small Business?”

At this filtering stage, you want to spend no more than a day on any one company that survived the initial and deeper qualitative filters. And you should only use the materials you have quickly available to examine the quantitative filters we describe in this chapter.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Margin

Our financial tests begin with a measure of profitability called EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA and revenue are the most basic pieces of financial information you will learn about a company. If you source through brokers, sales and EBITDA are always provided in the teaser and CIM; if you direct source, these two figures are part of the basic financial information that the owner will share with you as soon as you sign a nondisclosure agreement. EBITDA margin is simply EBITDA divided by revenue.

EBITDA margin tells you about the profitability of each dollar of sales and is a good initial test, for two reasons. First, this margin shows that the business is profitable, a central characteristic of enduringly profitable businesses. Second, as we discussed in chapter 10, “Enduringly Profitable Small Businesses,” we are looking for small businesses that serve some niche that either keeps others from entering the business or discourages customers from shopping elsewhere. Both increased competition and decreasing customer base, of course, squeeze down EBITDA margins. If a prospect steadily earns a superior EBITDA margin, that’s a clue that it possesses some critical quality that keeps competitors and customers from pushing down the margin. Look for large EBITDA margins of at least 20% for manufacturing and service businesses and 15% for higher-volume businesses like wholesalers and distributors. The small-company acquisitions that we describe in this book, for example, have EBITDA margins ranging from 20% to 50%. Margins at this level show that the business is attractively profitable.

The EBITDA margin is very easy to calculate. Just divide the EBITDA by the revenue:

Revenue

You already looked at an overall annual revenue number to make sure that the size of the company fits your requirements. Examining several other aspects of revenue records can help confirm that the company’s profitability will remain steady. As you move ahead with your investigation of the company, dig into the following questions.

Does this business have recurring revenues? Do the same customers purchase from the prospect again and again? In chapter 10, we looked at indirect indicators of recurring customers, but once you have access to sales records, you can check this directly. The company’s churn rate is the percentage of customers that buy in one year but not in the next. So, if a company’s average churn rate is 5%, it means that each year, 95% of its customers buy again in the following year, which would be outstanding retention. We suggest looking for businesses with churn rates of 25% or less. If the broker or seller has not calculated the business’s churn rate, you can calculate it from a customer list by just counting the names that drop off the list each year.

Do the company’s top five customers account for a lot of its revenues? The amount of revenue from top customers is called customer concentration. High customer concentration—if one customer provides, say, 40% of revenues, or three customers provide 70% of revenues—is a substantial risk to enduring profitability because those important customers have a significant impact on the fortunes of the company.

Is year-to-year sales growth coming from the right places? If you believe that the company’s customers are sticky, then most of the business’s revenue increases should be coming from market growth, price increases, or new product introductions rather than new customers won from competitors—because it should be hard to poach customers in this industry. If revenue growth is substantial and is coming from new customers won from competitors, or from just one or two customers, you need to look again at the company’s recurring revenue or its customer concentration.

Are sales cyclical? The same dip in sales that was merely disruptive for the business’s former owner—who has likely operated the company without any debt—may be fatal for you, who will have a considerable amount of borrowed money to return. Examine revenues in 2008 and 2009, the last very deep recession, to see a worst-case scenario. If EBITDA dropped 30% or more, this should be a deal breaker.

Quantitative Filters

In this chapter, we have added some quantitative filters to help you assess the enduring profitability of a prospect:

  Does it have a high EBITDA margin?

  Does it have recurring customers?

  Does it have fragmented customers and suppliers (no concentration)?

  Does revenue growth come from the right places?

  Does it have steady sales (not cyclical)?

Returning to Randy Shayler’s analysis of Zeswitz Music, he found that the company’s EBITDA margin in 2011 was almost 45%, which was very impressive. Most of the sales came from rentals, and the CIM indicated that those relationships with the schools recurred year after year. The CIM also contained information on customer and supplier concentration, and neither was a concern. The growth in rental revenues was slow and seemed to come from the relationships with school districts that were dissatisfied with their current vendor; the revenue from existing relationships was steady because the student population and the proportion participating in music programs with the schools was more or less constant. The long-term financial information provided in the CIM confirmed Randy’s expectation that the business was not cyclical and did not suffer a substantial reduction in rentals during the recession. Overall, his analysis convinced him that Zeswitz was an enduringly profitable business.

Next Steps

Zeswitz, like any other company that met a searcher’s initial filters and the deeper filter of enduring profitability, has to pass only one additional deeper filter before it survives the filtering stage and moves to preliminary due diligence. Remember, though, that filtering is iterative: As you learn more during the preliminary due-diligence stage, you’ll likely update your earlier conclusions, especially your assessment of enduring profitability. But now, we move on to the remaining deeper filter—the owner’s commitment to sell—a topic covered in the next chapter.