Responding to Stressful Times using Creative Approaches
No matter how you look at the future, your business is likely to face stresses and opportunities unlike what you have encountered in the past. Threats of a meaningful recession, supply chain disruptions, and challenging talent issues increasing interest rates are just a few of the main players. As a result, your business may not be positioned to respond to these factors, much less capitalize on them.
Let’s start with an issue that is top of mind in the media today: are we entering a recession or not? A recession is a period when in the economy retracts, and a gradual slowdown occurs in spending causing a significant loss of revenue for businesses. Recessions are a part of the cycle of an economy and impact many businesses, no matter how prepared they may be.
Historically speaking, recessions usually last around eleven months but can linger through a year or more depending on how serious they may be. These downturns in the market can be very difficult to predict and may begin at any point in time.
Even if we are not facing a recession, the issues created or uncovered due to COVID-19 have left many companies vulnerable. For this reason, it is imperative to take an impartial look at how your business operates. There are many ways to analyze your business and identify areas to improve how your company operates.
A Quality of Earnings Report (QofE)?
A QofE report is an in-depth analysis of a business’s financial statements, which should not be confused with a traditional audit or review which follows generally accepted accounting principles (GAAP) and will only offer a high-level assurance of the financials from the business.
In contrast, a QofE report will give you a guided in-depth tour of the company. These reports are recommended to help uncover disparity within the business and allows management to make crucial decisions as to how these issues will be approached.
Why are QofE Reports Typically Prepared?
Seller’s Perspective:
Gives an in-depth look at their company before making available to buyers to purchase and uncovers any issues that could plummet its value.
Buyer’s Perspective:
A QofE report will boost the confidence of the buyer encouraging them to move forward and purchase a company they are interested in. QofE reports provide evidence that support the likelihood of a company’s profitability.
A QofE Report will Examine:
Customer concentration and profitability
Income statement analysis
Working capital analysis
Strength of balance sheet
Summary of earnings before interest, taxes, depreciation, and amortization
Capital expenditures budget
Cash flow analysis
Review of major contracts
Having a drawn-out road map will historically show in detail how a business has performed and predict how it may react to various stressors that lay ahead. Below is an explanation of how each of these items above can be used to understand and destress your business.
Customer Concentration and Profitability
Two important aspects of your business are explored in this area: customer concentration and profitability. It is important to determine how vulnerable you are to any one customer. If you do have significant concentration, it is imperative to determine the strength of the relationship and the customers financial strength as well. Understanding where there may be issues is the first step to reducing your exposure.
Additionally, it is important to determine how profitable your major clients are. This includes margins, terms, how difficult are they to work, with as well as other factors. Not only do you need to understand their profitability, but you need to analyze it for the past two years to determine any trends regarding profitability, order size, terms, or similar issues.
Income Statement Analysis
Like understanding the profitability of a customer, you need to determine your overall profitability and uncover any concerns. This encompasses a review of each segment of your income statement for the past two years to establish if there are trends. In addition, you should seek out industry data to see how your company compares to others in the same industry.
Working Capital Analysis
A review of historical working capital is necessary to determine whether or not the overall health of the company is deteriorating. This is a multi-factor analysis and will lead to other issues. Working capital is a reflection of the activity of the company. A careful analysis will provide an insight as to the health of the rest of the organization.
Strength of Balance Sheet
Once again, a historical analysis is key to understanding the overall strength of the company. Does your company have too much leverage? What are the terms of the debt structure? Are you doing covenant checks to see if there are issues in the future? Do you have relationships with other financial institutions in the event there is an issue? It is important to understand how your balance sheet reflects your immediate future.
Summary of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
Typically, this is analyzed to reveal the true operating cash flow the company produces. Often, what this analysis highlights are unusual expenditures and expenses that are not necessary to the operation of the business. When used in this context, the “unnecessary expenses” are the focus. Once they have been identified they should be eliminated or at least reduced.
Capital Expenditures Budget
Understanding the true capital expenditures needed for a healthy business is extraordinarily important. We like to include maintenance in this area where the company is capital intensive regarding production equipment. Are the budgets based on needs, or are there contingency plans to defer expenditures if the company has a cash flow “hiccup”? Alternative plans should be put in place, including discussions with your bankers regarding financing options under different economic conditions.
Cash Flow Analysis
Now that you have an understanding of your major client’s profitability and forecasted sales, how your income statement should be adjusted, any unnecessary expenses that should be cut and capital expenditures, a true cash flow analysis can be done. Where necessary, this may end up being a weekly or monthly forecast for the next 12 months.
It is important the information you uncovered in the rest of your evaluation be made a part of this analysis. It may become an iterative process in that once you determine the cash flow other adjustments (such as capital expenditures) may need to be adjusted to reflect reality.
Review of Major Contracts
This is typically an area covered under legal due diligence. However, the results of this review can have major impact on the areas addressed above. What commitments do you have with your customers? Are you following the terms of the agreements? Are the terms with your suppliers consistent with the commitments you have with your customers? Do you have a 12-month fixed price for your customers but not with your suppliers?
You should work closely with your legal team to ensure you understand how these terms affect your business. What can be changed or modified to protect your business should be done. What cannot be changed within contracts require alternative plans that will be reflected in your cash flow and working capital analysis.
Advisors play a key role in helping you understand how to go through this process. First, it is likely you don’t have the in-house expertise for all the needed analysis. Second, a trusted advisor with good experience can give you impartial advice regarding the issues facing your business. For more information on what to look for in an Advisor see our What Makes a Good Advisor and What Characteristics to Look for When Searching For a Good Advisor blog.
Navigating stressful times, recession or not, requires vigilance, foresight, and determination. Looking at your business through a different lens allows you to take a fresh look at the strengths, weaknesses, opportunities and threats you face. This approach allows you and your advisors to put aside preconceived ideas of how you should run your business!