Kaufmann

Are You an Expert in the Corporate Finance Area?

Are you an expert is corporate finance area?  Can you help businesses raise money for their businesses or market them to investors?  If so, the Houston Business Show wants to visit with you.  Contact us at Info@HoustonBusinessShow.com.  We are not only looking for experts in Houston, but the rest of the country.  If you are in Chicago, New York, Detroit, Austin, or other cities that mean business, we want to hear from you.

Processes, Controls and Value

Which statement is true?

1. To properly manage your company and maximize value, you need to have good processes or controls.
2. To properly manage your company and maximize value, you need to have good processes and controls.

The answer is statement 2. Why? After all, at first glance, both statements appear to say the same thing. In fact, each has a distinct meaning and a significant, if subtle, difference.

Statement 1 implies that processes and controls are the same thing, that the words are synonymous. However, processes and controls are not at all the same and each one has an important impact on the overall value of your company.

First, let's look at controls. I am not referring here to the operational sense, where controls are mechanical or electronic devices that ensure a production process runs as intended. Instead, I am talking about the financial, or more correctly, the accounting definition of the word. In that sense, controls are defined as procedures used to assure accuracy in the record keeping function. You have controls to make sure that all financial transactions are recorded and that they are recorded in a proper and consistent manner.

When we attempt to place a value on a company, we base our value in part on an analysis of the company's financial data. How do we know the financial information is accurate? We rely on the assumption that the company has financial controls in place, and that those financial controls have been reviewed by a CPA to ensure that the accounting controls are in place and are enforced by the company.

Accounting controls only give us a partial picture, however, because all they tell us is that the company is giving us numbers that are accurate. When we value a company, though, we also want to know how well managed the company is and for that we must look at the company's processes. Specifically, we want to know just how efficiently and effectively the company operates--how well can the company operate on its own without the need for constant intervention by the business owner or management team?

I will illustrate with an example, but first let's define what we mean by a process. Simply put, a process is a series of procedures or activities that are taken by employees to achieve a specific goal established by management. To maximize a company's value, you not only need processes, but the processes must be both efficient (get the job done quickly) and effective (get the job done).

To clarify the difference between controls and processes, let's take the simple example of filling a sales order. The normal process would be as follows:

1. A purchase order is received from your customer, and the customer requests credit terms.
2. The purchase order is sent to the credit manager for approval.
3. The credit manager reviews the request, approves the order and sends it to the production department.
4. The production department reviews the purchase order because the production manager cannot order inventory or begin the production process unless the order has the credit manager's approval. After noting that the credit manager's approval on the order, the production manager issues his own purchase order for inventory and sends the order to the purchasing manager for approval.

The preceding sequence includes a number of accounting controls. Inventory cannot be ordered without the credit manager approval and no money can be spent to purchase inventory without the purchasing manager's approval. At the same time, you will note that the purchasing manager is not able to approve payment without a signed purchase order from the production manager.

So, from an accounting perspective, the CPA will come in and review the preceding sequence and examine the company's financial records to verify that the procedures are adequate and to confirm that the procedures are being followed. That is the control aspect.

The process perspective would be examined perhaps by a CPA or perhaps by another individual, such as the chief operating officer. Instead of asking if controls are in place and if they are being followed, the COO will look at the sequence of events and try to determine if things can be done faster, better and with less cost. So, when reviewing the preceding procedures, the COO may ask such things as:

1. How much time does it take for the purchase order to go from sales to the credit manager? Can the purchase order be delivered to both places at the same time?
2. How long does it take the purchase order to receive credit approval? What are the steps the credit manager takes to determine if he will approve a purchase order? Can some credit approval limit be delegated to the sales area to speed up the process and reduce the workload on the credit manager?
3. Is it possible to automate the process in any way? For example, once the credit manager gives his approval, can the computer system automatically generate a purchase order for the production manager to approve rather than having the production manager spend the time to create one?
4. How many days can we save on the entire process?

Any improvement in efficiency or effectiveness will speed up the entire process and ultimately result in lower costs and higher profits, which can only increase the overall value of the company.

So remember, as you work on improving the value of your company, focus not only on having the proper financial controls in places, but also on making sure that your financial processes are as efficient and effective as they can possibly be.

It's All About Value

What is your company worth?  Is the value high enough to attact investors?  Can you use your stock instead of cash to purchase another company for acquisition?  How much can you get for your company when you want to exit?  What can you do daily to increase corporate value?

Do you consider these questions as part of your ongoing management of your company, as part of efforts to achieve your long term goals and make your vision a reality?  If you're like most people, such pondering is more of an infrequent exercise, perhaps even considered to be a luxury, instead of a routine process.  Which is shame, because when you cut to the chase, it's all about value.

Sooner or later, you are going to exit from your business.  You may intend to liquidate your company and retire, you may want to pass it on to your children, or you may be planning to sell to another company at some point in the future.  Whatever the case, the more value there is in your company, the more dollars you will receive in the long term and, just as important, the more options you have in the short term.

So how do you build value in your company on a daily basis?  By improving your internal systems so your company can run on its own and, to the extent possible, individual employees can always be replaced, from clerks to executives.  How does improving internal systems improve value?  By enabling you to obtain financing and increase sales.

Investors not only want to see a company that is profitable, but also a company that can perform.  This means producing a quality product, providing excellent customer service, delivering on time every time, and generally understanding your target market's needs and meeting those needs better than anyone else.  If you can do this, you can attract financing that will support future growth by enabling you to invest in equipment and personnel, as well as by making it possible for you to acquire other companies to accelerate growth.

Interestingly, larger companies that you might want to sell to use the same evaluation process when choosing vendors that investors use when deciding where to invest their money.  If you can show that your company operates well, has an effective management team, produces a quality product that is delivered on time, and offers excellent customer service, you are more likely to become an approved vendor.  Once you do become approved, your sales will increase and it becomes that much easier to be an approved vendor to other companies. 

Once you reach this point, you can offer the following:  the ability to raise debt or equity capital, a built-in customer base, and a defined stream of revenues.  All things being equal, if you have one or all of these characteristics, your company will be more valuable than others that do not.

So, what is your company worth?  What can you do today to increase corporate value?

Financing Your Business – 5: Funds Flow

This is the fifth article in a series about financing your business.  We previously reviewed potential financing sources, the lender’s perspective, events that cause the need for financing, and ratio analysis.  In this article we will discuss how funds flow through your business. 

It is really a common sense topic that does not require a lot of explanation, but it is worth a brief mention because funds flow is an integral part of determining if you need to incur debt and the proper debt structure for your company.

To understand your financial statements, it is important to clearly understand how money flows through your business.  The best way to keep it simple is to think of the Income Statement as activity and the Balance Sheet as results.

Another perspective is that the Income Statement shows the money you earn and spend.  The Balance Sheet shows what you bought with your money and how you paid for it.

You always start with the Income Statement.  You start at the top with revenues, and then move down, subtracting expenses in the process, until you get a net income.  The net income is moved into the equity section of your balance sheet as retained earnings.  Retained earnings are used to purchase the assets you need to operate your business.

But what if your asset costs exceed your total retained earnings?  Then you need additional funds.  If you are unable to raise additional equity, then you need to borrow the money you need.

When you lack sufficient equity to pay for all of your assets, and have to incur debt, it is important that you structure your debt properly.  We will go into this in more detail in the next article, but for now it is sufficient to note that you should use short term debt to buy short term assets and long term debt to buy long term assets.

What does that mean?  It means that you use bank lines of credit and vendors’ credit to pay for inventory and carry your accounts receivable, and that you use term loans or capital leasing to purchase capital assets.

When you think about this, you come to the common sense conclusion that the more profit you earn, the higher your retained earnings, the more funds you have available for asset purchases, and the less you need to borrow.
In the next article we will take a look at using the proper debt structure.

Financing Your Business – 4: Ratio Analysis

This is the fourth article in a series about financing your business.  We previously reviewed potential financing sources, the lender’s perspective and events that cause the need for financing.  In this article we will look at ratio analysis and how it can help you get valuable information about your business so you can make proper and timely decisions.
               
The value of ratio analysis is that it enables you to compare your financial results from one period to the next on an “apples to apples” basis instead of on an “apples and oranges” basis.  For example, let’s say that you made a $10,000 profit in one period and in the next period you made a profit of $25,000.  Based only on the dollars you earned, you would think that your bottom line was improving, but what if I told you that your profit margin in the first period was 10% and in the second period you had a 5% profit margin?  The $25,000 profit does not seem to be as much of an improvement, does it?

In this example, comparing dollars from one period to the next is the “apples and oranges” approach; comparing profit margins is the “apples to apples” method.

Another benefit of ratio analysis that it indicates what you must do to solve a problem you may uncover.  For example, assume that your accounts receivable are $10,000 in March and $15,000 in April.  At first glance, it would seem that you are doing well, because if your receivables increased, then your sales must have increased as well. 

However, your accounts receivable could have gone up because your sales remained at normal levels but your existing customers were taking longer to pay.  This would tell you that you need to step up your collection of customer accounts.  It’s also likely that your credit policy needs to be reviewed to determine if (a) you are following the policy and (b) the policy is too lax.

Here’s a quick list of ratios you can use to gauge your financial health:

• Current Ratio – Compares current assets to current liabilities to give an indication of your firm’s liquidity.  It answers the question:  If I convert all of my current assets to cash and pay off my current liabilities, how much cash do I have left over?
• Quick Ratio – Same as the current ratio, but excluding inventory from the current assets.  Considered by some to be a truer test of liquidity, this ratio answers the question:  If I cannot liquidate my inventory, would I be able to pay off all of my current liabilities just using the cash on hand and monies I collect from receivables?

A note about the current and quick ratios.  You generally want to have a ratio of 1:1 or higher.  In other words, you want your current assets to at least be equal to or greater than your current liabilities.  If you are consistently below 1:1 it could mean that you are not collecting receivables on a timely basis, that your inventory is not turning over fast enough, or that you are taking too long to pay your vendors.  It could also mean that you have the wrong debt structure and that you are using short term debt to finance long term needs.

• Turnover Ratios – These are used to determine how long it actually takes to collect receivables, sell inventory, and pay vendors.  Turnover ratios are used to determine the liquidity of your firm.
• Debt / Worth – This ratio compares your total debt to your company’s equity.  In other words, it answers this question:  How much of your assets are paid for with debt, and how much are paid with equity?  The answer determines your ability to borrow more money, and also has an impact on your cash flow:  the more debt you have, the more you have to use profit to pay debt and the less money you have to reinvest in your business.  This ratio is a leverage ratio.  In other words, how leveraged are you, how much of your business is financed with debt as opposed to funds generated by ongoing operations?
• Margins – These are profitability ratios, used to determine not only how profitable you are, but also your ability to earn a consistent level of profit over a period of time.  Common margins used are gross margin (profitability after paying the cost of materials, inventory), operating margin (profitability after paying all ongoing costs incurred to run the business), and net margin (profitability after all expenses have been paid – the “bottom line”).
• Times Interest Earned – This compares profit to interest expense to determine your ability to service debt.

In the next article, we will look at the flow of funds in your business and working capital.

Financing Your Business – 3: The Need for Financing

This is the third article in a series about financing your business.  We previously reviewed potential financing sources and the lender’s perspective.   This time we are going to take a look at the need for financing and the events that cause the need to borrow.

What are the primary reasons a company borrows money or seeks funds from outside investors?  The obvious answer is to obtain cash for the business, but how will the cash actually be used once it is raised?  In other words, what exactly causes the need for financing?

There are actually quite a few answers, but just to summarize a few, the need for cash can occur for a variety of reasons:

1. A company experiences an increase in its costs but is limited in its ability to raise prices.
2. There is a slowdown in the collection of accounts receivable and funds are needed to pay ongoing operating expenses.
3. Suppliers decide to reduce the time you can take to pay their invoices, so you cannot wait for customer to pay you before you pay your supplier.
4. You have to increase your assets to support growth in revenues, which you can sometimes anticipate, but which may also be unexpected.
5. You have not properly aligned your debt structure to match the asset side of your balance sheet.  Short term debt should finance short term needs (working capital) and long term debt should finance long term needs (purchases of land, buildings, equipment).

There are others, but these are some of the most common reasons.  As you can see, each one of these reasons is a symptom of a deeper problem that management must solve, so it is important to remember that the need for cash is actually the symptom of a problem, not the actual problem itself.

It is all good and well to know what some of the causes are that force you to seek external financing, and that if you need cash then you probably have an operational problem that needs correcting.  How can you determine that such problems exist, or may occur, before they actually happen and you find yourself in a cash crunch?

The answer is to constantly obtain and review the information that will provide the answers.  With the proper information about your business, and accurate financial statements, you can identify the causes.  Fortunately, today’s technology can automate the information gathering and processing process so you can devote more time to using the information to make decisions instead of spending a lot of time just gathering and manipulating the data to get the information you seek and need.

The tools you use to get the information you need are:

1. The balance sheet, which shows your financial condition at a point in time, and provides insight into your company’s liquidity and leverage positions.  Liquidity is a concept that relates to how easily or how quickly you can convert your assets into cash.  Leverage is a concept that relates to how much debt you have relative to your total assets or equity.  Generally speaking, the more debt you have, the less able you are to raise cash from the assets you own.
2. The income statement, which shows the results of your company’s operations over a period of time.  In addition to showing how much money you earn from selling your product or service, the income statement identifies the
   1. Operating expenses, which are your costs related to operating your business;
   2. Operating profit, which is the amount of money available to cover your non-operating expenses, such as loan payments;
   3. Net profit, which is an indicator of your firm’s performance over the long term because it reflects how much money you have earned to reinvest in your business.
3. The statement of cash flows, which shows the net inflow or outflow of cash into or out of your business over time.  Remember that you can be very profitable and still go out of business because you lacked the cash you need to survive.
4. Ratio analysis, which makes it possible to compare your financial condition from one operating period to another so you can effectively manage your business and anticipate problems before they occur.

Each one of these tools provides vital information, but you can only get a complete picture of your financial condition if you use all of these tools together.  It’s like building a house—you can’t use a hammer for everything; sometimes you need a wrench, a screwdriver or a pair of pliers.

In the next article we will take a look at ratio analysis and how you can use it to quickly get important data on the financial health of your company.

Bruce Kaufmann

Financing Your Business – 2: Lender’s Perspective

In this, the second article in a series about financing your business, we are going to examine how a lender views your business and what he looks for when you request financing.  To keep things simple, in this article, I will use the term lender to mean both those that lend money to your company—banks, finance companies, factors—as well as those that invest in your company—venture capitalists, angel investors, and investment bankers.

The first thing you want to remember is that every request for financing you make is a selling activity.  No matter how good your business idea, no matter how financially sound your company is, you are only one of many requests that a lender sees every day.  And there is always someone who is in better financial condition than you are, or who will be an easier deal to close than you will.

Those who lend money are judged by the following criteria:

1. How many deals do they review?
2. How many deals do they close?
3. What is the amount of each deal (larger is better)?
4. How profitable is each deal?

Get the picture?  Lenders are salespeople.  Their product/inventory is money, and they don’t want it sitting idle.  Instead, they want it out in the marketplace, where it will generate revenues (interest).

However, you need to understand that selling loans or equity investments is not quite the same as selling a product or service.  For one thing, once a company sells a product or service, they do not want to take it back.  The sale is closed, the profit has been earned.  End of story, on to the next sale.

Lenders, though, definitely want the money back.  Repayment of the loan or investment is absolutely necessary if the lender is to receive the required return on his investment.  In addition, lenders tend to be highly leveraged, which means they make loans with a little of their own money and a lot of other people’s money.  Being leveraged means that any time a loan is not repaid, it will have a significant, and severe, impact on the lender’s financial condition.

So you can understand why lenders are going to be very careful when they decide who gets to borrow their money. 

With that in mind, let’s take a look at the three basic questions lenders consider when they evaluate financing requests and try to decide who gets to borrow money.

These questions apply to anyone that lends or invests money—it does not matter if it is a loan, an equity investment or a combination of both.  However, the specific answers depend on the type of lender and the risk that the lender is willing to take.

For example, banks tend to be short term lenders and avoid very risky credits.  Therefore, they will try to obtain collateral to secure their loan and will not make loans to companies that have insufficient assets to pledge, have a poor financial condition, or inadequate cash flow.

Equity investors, on the other hand, seek out the riskier investments and higher rates of return.  Consequently, they will not necessarily seek hard assets as collateral, and will not be concerned if (at the outset) the company has insufficient cash flow or a poor financial condition.

In both cases, though, these three questions must be answered:

1. Purpose – Why do you want the money?  How will you use it?  What has happened, or will happen, that causes the need for you to seek out financing?
2. Repayment – How will you repay the money?  If you are seeking short term debt, will your ongoing cash flow be the source of repayment?  Will you depend on your customers to pay you in order for you to repay the debt?  If you are seeking an equity investment, do you expect the value of your company to grow to the point where you can sell it and thus raise the funds needed to repay the lender?
3. Collateral – What is the alternative to the lender if your intended source of repayment fails to materialize?  In the case of a short term loan, will your assets have sufficient value so they can be liquidated and pay the loan in full?  How much will it cost the lender if he has to go through the liquidation process?  If you anticipate an equity investment, will the lender be able to take control of your company should you be unable to execute your business plan?

So do not forget the lender’s perspective when you are seeking money for your company.  Anything you can do to give the lender what he needs, and to make it easier for the lender to approve your request, will only enhance your ability to get the financing you need, when you need it.

Financing Your Business – 1: An Overview

This article is the first in a series that will discuss various aspects of financing your business.  Here is a list of the topics that we will cover:

1. The potential financing sources that are available to you.
2. Understanding the lender’s perspective.
3. What causes the need for financing.
4. How to identify the events that cause the need for financing.
5. Using the proper debt structure.
6. Preparing a financing package.

Let’s begin by taking a look at some of the potential financing sources that are available to you.  Most business owners think that their only option is to get financing from a bank, from savings, or from friends and family.  Actually, there are more sources available to you:

1. Private Investors – This group includes not only your friends and family that are willing to take a chance on you, but also such entities as venture capitalists and angel investors.  Keep in mind that your chances of getting funding from a venture capitalist are very slim; even if you have a product or service that can grow quickly, provide a high return, and offer a quick exit, the venture capitalist may still choose another investment over yours.  You may be better off either borrowing money from friends and family, or creating a Regulation D offering to allow your friends and family to participate in the growth of your company.  A note of caution:  if you do tap relatives and friends for funds, be sure to do an arm’s length transaction, i.e., as if you were total strangers.  Do it right, because you want your friends and family to stay your friends and family, no matter what happens.
   
   
2. Banks – This is a very familiar financing source.  What you want to remember about banks is that they can only lend to your business if your business is established and is generating a profit, has a positive cash flow, and does not already have too much debt.  Even if all of these things are true, and even if your company is incorporated, if you are the sole owner you need to be prepared to personally guarantee whatever debt the bank grants to you.  If your company does not meet the previously mentioned criteria, you might still qualify for a loan guaranteed by the Small Business Administration or, if your personal credit is good, a personal line of credit.
   
3. Factors – A factoring company may seem very similar to a bank, but there are critical differences.  A bank bases its lending decision on the overall cash flow and financial condition of your business, and will take assets such as inventory or machinery as collateral.  A factoring company does evaluate your company’s financial condition to verify that your business is viable, but only provides financing against your accounts receivable.  Technically, a factor does not lend money to you.  Instead, he buys your accounts receivable and assumes the collection risk.  Be aware, though, in many cases, the factor may require you to buy back the accounts receivable if your customer does not pay.  A factor is a good alternative if you do not qualify for bank financing, and can also provide additional credit if you have exceeded the limit of your bank line of credit.  Factoring is a riskier form of lending than bank financing, so be prepared to pay a higher interest rate on factored transactions.
   
   
4. Finance Companies – Finance companies are similar to factoring companies in that finance companies are asset-based lenders.  In other words, they lend to you based on the value of your assets, as opposed to banks, which base their decision more on your overall financial condition and cash flow.  Finance companies establish a “borrowing base”, which is the maximum amount of money that you can borrow.  The borrowing base is based on the value of your receivables and inventory.  This financing is a good alternative if your company’s financial condition is less than stellar, but you have receivables and inventory that have good value.  The finance company is more involved in the management of your credit line and also takes a bigger risk than a commercial bank because the finance company relies only on specific assets for repayment.  Since the lending process is more labor intensive and the risk is higher, the finance company will also charge a higher interest rate than a commercial bank.
   
5. Leasing Companies – Leasing companies are an excellent source of financing if your primary need is to purchase a piece of equipment.  You also have to meet certain credit standards to qualify for lease financing, but a lease transaction is a good way to manage your cash flow.  This is because a good leasing company will try to match your monthly payment to an amount that is within your monthly budget.  Also, the leasing company will factor in any residual value of your equipment at the end of the term of the lease.  For this reason, the leasing company may be able to provide longer terms than a commercial bank.  You may pay a higher rate with a leasing company than you would with a bank, but the leasing company may be more likely to provide a monthly payment you can afford.
   
   
6. Purchase Order Financing – You may find yourself in a situation where you receive a purchase order for a very large amount, yet you do not have the money available to purchase or manufacture the product for your customer.  A purchase order lender will advance money to you so you can buy inventory and manufacture your product to fill the order.  This type of financing is not technically lending.  It is really an equity rental; the purchase order lender “lends” his equity to the transaction.  For this reason, the interest cost is much higher than in other types of short term financing.  Be aware that this type of financing is only viable if you have very high gross margins and the transaction has a short (less than 45 days) time frame.
   
   
7. Suppliers – Finally, do not forget trade credit, which is an excellent source of financing if you can get it.  It is a resource you should strive to obtain and, once you get it, fiercely protect.  Over the long term, a good relationship with your supplier, more so than with any other lender, can make the difference between your company’s survival or failure.

In the next article in this series, we will look at financing your business from the lender’s perspective.

Copyright 2007 Kaufmann Capital Advisors

Inside the Black Box

Every day, technology becomes a more integral part of our lives.  As the technology gurus find even more ways to automate daily tasks, either with new, compact hardware or a sophisticated software program, I am seeing more requests for funding to develop and commercialize a new technology.  Such requests are often referred to as “black box” requests because, to the financial investor, the entrepreneur is offering a piece of hardware that looks pretty simple on the outside, but inside is filled with all sorts of technological hardware, or sophisticated software, that the average person just would not be able to understand.

What many entrepreneurs do not understand is that the odds are immediately stacked against you if you present a black box funding request to an investor, even those who specialize in funding high technology investments.  This is because investors have learned that black box funding requests typically focus too much on how the black box works, instead of discussing how the black box can make money.  Not just a little money, mind you, but enough money that the investor can exit within five years and realize a proper return on the investment.

I am not saying that you should not explain how your product works, but keep that explanation in context, part of a more comprehensive explanation of the existing market problem and how your product solves that problem.  Keep in mind what the investors want to know:

1. How large is the market and how fast is it growing?  Is it big enough that if I only get a very small slice of the pie I can still make a lot of money?
2. What is the problem, now and in the future, that your product attempts to solve?
3. How does your product solve the problem and why is your product a better solution than what is currently available?
4. What is your plan for bringing your product to market and generating revenues?  Will you be able to earn a profit?  How soon will you earn a profit?
5. Are you capable of executing the plan to make money from your product?  Who else is on your management team?  Does your management team collectively have the experience and ability to make your plan work?

Notice that only item 3 asks about product information.  Even then, how the product works is only a partial answer to this question.

Also keep in mind that you will have a much harder time obtaining financing if your technology represents a radically different way of doing something, instead of an improvement over current processes.  There is a much bigger risk in being first to market.  If you are first, you will be viewed as less likely to survive, much less be the dominant player, in the long term.  This is because those that follow you will not have to educate the market on the benefits of your product, and they will be able to learn from your mistakes.

Copyright 2007 Kaufmann Capital Advisors

Soapy Water and Accounting Controls

Podcast! Soapy Water and Accounting Controls

We discuss the importance of having and testing accounting controls to prevent cash losses.