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With the economic upheaval of the past year, many business owners are facing declining revenue. We thought this would be a good time to discuss how shrinking business volume may affect the value of your business.
Determinants of Value:
The key to preserving value is to preserve Earnings Before Interest, Income Taxes, Depreciation and Amortization, better known as “EBITDA,” to the extent possible. (See Glossary for full definition of EBITDA.)
The two factors that transform Gross Revenues into EBITDA are Gross Margin (which is the net after variable costs) and Net Margin, which is what’s left after expenses are covered. EBITDA, for valuation purposes is the result of “recasting” which converts a normal income statement into a statement of “Normalized Net Operating Cash Flow”.
Keep an eye on your margins:
There is a common tendency to look at just Gross Sales to get a feel of how your company is doing. Maintaining the same Gross Sales while experiencing decay in net margin means the value of your company is decaying as well.
Watch Your Pricing:
In declining markets, there appears to be a tendency to lower prices to attract business. While it may increase gross sales, the effect on net margins can be devastating. Price wars can often lead to bankruptcy.
Understand Your Accounting System:
Most small businesses do a poor job of cost accounting, especially in differentiating COGS items from fixed expense items. Your accounting system may make this difficult. You may need to develop some spreadsheets in Excel which better reflect this distribution.
Theoretically, gross margin percentages should remain about the same regardless of the volume of sales, and are more closely determined by pricing than any other factor. In cases of declining sales, it is the fixed expenses which can really destroy cash flow, which are overlooked until it is too late.
Many businesses, in hope of a recovery, are reluctant to cut overhead (meaning employees mostly) and this can have a devastating effect on EBITDA. It is hard to cut key employees, but sometimes in the interest of survival it is necessary – even if they will be difficult to replace once there is a business recovery.
Develop and Fine Tune a Marketing/Business Development Program:
Our experience shows us that a common problem for small businesses is the failure to develop and maintain effective marketing/business development programs. In most cases, just doing what you did last year will not produce the benefits you need. There are experts around who know how to drive business, and the cost of doing so could be significantly less than the reduction in margins that occur when you try to compete by cutting prices. An effective marketing consultant can be figuratively worth his weight in gold.
Deleveraging will not Impact Value:
While deleveraging (eliminating debt) will improve your net income, it will not affect EBITDA – which is the cash flow before debt service. And EBITDA is the main determinant of asset value from the income approach in appraisals.
While declining sales is a frightening phenomenon, close management of margins can help mitigate its effects on cash flow and preserve business value. If you can ride out the storm, your company will be even stronger and well-poised to come out of the slump when economic conditions improve.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.