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The good business equation

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Phil Wright - Menzies Accountant

Phil Wright – Director

The key to business growth lies in driving maintainable profits up and removing risk from the business in order to increase value and attract a higher price. It sounds simple, but requires strategic vision and planning.

For most SME’s their value is based on the following equation:

Maintainable profits x a risk multiple = business value

The higher the risk of the business, the lower the multiple applied, meaning a reduction in overall value. As an example:

Maintainable Profits Risk Multiple Business Value
£300,000 3 £900,000
£400,000 4 £1,600,000

If the business could increase its’ profits and reduce is risk, the indicative value is nearly double!

This shows the importance on working on both sides of the equation. The latter valuation (£1,600,000) may well become the ultimate ‘vision’ for the business owner (given that the business value and their personal financial aspirations are entwined) but what does this mean?

The company needs to grow its profits and reduce its risk and this will form the basis of the company’s strategy. To ensure the company has the best opportunity to hit its targets, and achieve the vision, the strategy needs to be broken down into smaller manageable tasks, with management given accountability for their success, and regular tracking.

But where do we start?


Profitability

In our experience, most SME’s are good at splitting revenue by product, service and customer, but struggle when understanding the profitability of each. The devil really is in the detail, and if you haven’t got it, you need to get it! If you are not sure which products or services are generating gross profit (and helping to cover your overheads), how do you know what to do more of, or less of?

Our starting point when working with clients is challenging them to obtain, and interpret this key data. Once we understand the profitability data, we can assess the types of products and services we offer and to which customers. This information governs the company’s strategy and subsequent sales and marketing activity. Overlaying your products and services over your customer base and exploring the ‘gaps’ should provide some quick wins, as sales to existing customers, we all know is much easier than winning new business. Also look for smaller ‘easy wins’ where the aggregation of these ‘marginal gains’ can have a great impact.


Creating a blame free business culture and understanding risk

Risk

The inherent risk in an industry will play a huge part in the company’s valuation but the company’s approach to risk mitigation can seek to mitigate this. The company’s understanding of the riskiness of each area of its business is also critical.

If the company operates in areas where compliance with laws and regulation is important, what is there approach to training and ensuring that best practice is instilled in the team? Do all people have the right training and qualifications and are any breaches challenged? The reliance on one key customer or supplier can mean the business is over reliant and subject to disruptions if there are breakdowns in the relationship. Revenue, and therefore profitability, could suffer in both scenarios given any supply chain disruption could let down key customers and see them move to competitors.


People

Attracting, engaging and motivating key people is essential. A well-established senior team at the helm should make business more attractive to a purchaser (and worth more) compared to a business where a lot of goodwill and relationships sit with one key individual. Benchmarking salary rates, employee incentive packages and share options all come with a financial ‘cost’ but can be outweighed by securing good quality team members for the future. Many clients do not have strong terms and conditions. You should review how robust your terms and conditions are and the legal validity of the content, along with considering the terms you enter into with your customers and suppliers; do you sit in a position of strength, or are you open to punitive damages for late delivery? If so, can you pass this onto your supply chain – where does responsibility lie?


The power of data in business

Lack of financial information is often seen in SMEs, with many businesses not understanding their working capital cycle fully, having access to key profitability data as we’ve already talked about, and no detailed rolling projections (cash flow, profit and loss and balance sheet) to stress test any change in the business or running ‘what if…?’ scenarios to gauge the business impact.

By having an appreciation of these business risks, alongside those industry specific should go some way to reduce the likelihood of an unforeseen event crippling the business. I’d encourage you to undertake you own risk assessment by department and action those promptly that have a high likelihood of happening and where the impact could be significant.

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Posted in Blog, Business Services, Healthcare, Hospitality & leisure, Manufacturing, Not-for-profit, Retail, Technology, Transport & logistics

Phil Wright - ACA

Director

For more information about the good business equation and how you can apply these principles to your business, contact Menzies Director Phil Wright.