by Anita Sherman, CPA | Managing Partner
In my April 19, 2012 article, I discussed the personal financial planning needed to get yourself and your family ready for a business transition or sale. In my March 22, 2012 article, I discussed the importance of preparing key employees for transition. This week I want to focus on preparing the company’s financial statements for a transition or sale, in order to maximize the value and provide you peace of mind.
Your company is most likely your single largest asset, or at least a significant part of your financial estate. In a transition to key employees or family members, you most likely will be looking for cash flow payments from them, or the company, for years to come. But what condition will the vehicle (company) be in when you turn loose of the steering wheel? Will it be in good mechanical shape able to carry a heavy load, or will it appear old and needing a lot of repair? I know which one I would want.
What do we mean by good mechanical shape? Here are some examples:
- A high current ratio (current assets divided by current liabilities) of at least 2:1 (higher is even better).
- A low debt to equity ratio (total liabilities divided by total shareholder equity) of no more than 3.5:1 (lower would be better)
- Continuous reinvestment in the business by keeping equipment and systems up to date (looking at the cash flow statements, over a period of 5-7 years, property additions should approximate the amount of depreciation taken over that same period of time).
- Good profitability trends. There are a number of different profitability ratios, and some vary by industry. A common one used by banks is the debt service coverage ratio (Earnings before interest expense, taxes, depreciation and amortization [EBITDA] divided by the total of interest expense plus next year’s required principal payments) which should be at least 1.1 to 1.0, or higher. Banks will frequently reduce the numerator by dividend distributions and property additions not funded with long term debt.
Interestingly, if you are planning to sell your business, sellers are looking at the same factors, with perhaps even more emphasis on the last five years of earnings. In fact a multiple of earnings (EBITDA actually) is often the formula seller’s use in determining what they will pay for a business. If you are planning a future sale, it would be wise to eliminate unnecessary perks, excessive compensation and discretionary expenditures that don’t add value to a business. Focus on having a strong bottom line, but continue to make investments in people, training and maintenance.
Whether you sell your company to outsiders or transition to your family or employees, you can leave a strong legacy to those that follow you. You’ll also achieve greater peace of mind for yourself knowing that you left a strong company, in good mechanical shape, which can generate the cash needed to pay you when you leave.
In our next article, I want to cover some ideas on how to minimize taxes as you transition or sell the business.