no more smoke and mirrors: knowing and demonstrating business numbers

No More Smoke and Mirrors:Knowing and Demonstrating Business Numbers

New Orleans Entrepreneur Week 2016

A. J. BrigatiMBHC LLC

www.mbhcadvisorygroup.com

Problem Statement

Two frequent mistakes entrepreneurs make whendiscussing or pitching their business model:

1. “not knowing your numbers”2. “your valuation is insane”

Objective

To empower entrepreneurs, particularly early stage, byproviding a brief overview of the essentialexpectations necessary to express the financialstability, cost containment, growth and valuation ofthe business to include financial statements, coreratios and industry metrics to arm them with aconfident foundation to demonstrate they “know theirnumbers” and are appropriately valuing theirbusinesses.

Assumptions

You are an innovator or disruptor with a passion andexpertise for delivering your product or service;however, not knowing key financial indicators is animmediate red flag which could ultimately determinewhether or not a venture capital investor will trusttheir investment with you. It could make or breakavailability of early stage funding when you need itmost.

Expected Outcomes

As a result of this presentation and discussion, participants willbecome familiar with and discover the need for maintaining thefollowing:

1. Financial Statements (including the balance sheet, profit andloss statement, cash flow statement, statement of retainedearnings, management letter)

2. Core Ratios (including the Primary Reserve Ratio, Net IncomeRatio, Return on Net Assets Ratio and Viability Ratio)

3. Industry Key Performance Indicator Metrics (using a retailexample to include same store sales, sales per square foot,inventory turns and conversion)

Financial Statements

1. Keep your books as if you are accountable to investors fromday one.

2. Maintain financial statements on a model of scale as if you werea publicly traded company. If you start this way, it allows you torefine your skills at producing accurate and potentially audit readyfinancial statements. You do not want to learn how to reportfinancials when you get your first investors. (similarly, youprobably will not get first investors without accurate financials).

3. Know the highlights from your financial statements eachquarter and each year.


Balance Sheet

Summarizes a company's assets, liabilities and shareholders'equity at a specific point in time representing the state of acompany's finances at a moment in time.

The core ratios (more later) can be derived from the balance sheet.

Gives investors an idea as to what the company owns and owes,as well as the amount invested by shareholders.

Typically used by lenders, investors and creditors to estimate theliquidity of a business.

Formula: Assets = Liabilities + Shareholders' Equity


On behalf of my investors, I might ask:

How much debt does the company have?

What are your payables and to whom?

How much inventory do you have?

Who are your shareholders and how much equity dothey have?


Profit and Loss Statement

1. Summarizes the revenues, costs and expenses incurred duringa specific period of time (quarterly, annually)

2. Provide information about a company's ability or inability togenerate profit by increasing revenue, reducing costs, or both.

3. This is essentially your income or operating statement.

4. Formula: Revenues – expenses = net profit (loss)



What were your sales this past year?

What were your cost of sales?

What was your net profit (loss)?


Cash Flow Statement

1. Reports all cash inflows a company receives fromboth its ongoing operations and external investmentsources, as well as all cash outflows that pay forbusiness activities and investments during a givenquarter.

2. It is especially useful when there is a divergencebetween the amount of profits reported and theamount of net cash flow generated by operations.Gives a more timely snapshot than the incomestatement as the latter is often a product of accrualaccounting.


Statement of Retained Earnings

1. The amount of net income which is left in abusiness after the distribution dividends orwithdrawls by owner is called retained earnings.

2. Formula: Retained Earnings = Beginning RetainedEarnings (carryover) + Net Income − Withdrawals byOwners



How much cash does the business have on hand?

How much of the earnings from last year(s) werecarried over or how were they spent?

What is your cost of sales?

What is your profit margin?

What is your break even?

Financial StatementsManagement Letter

1. Issued by the company’s CPA firm to the owners and seniormanagement in connection with an annual audit of privately heldcompanies.

2. Communicates internal control related matters

3. Discloses presence or absence of control deficiencies in the financialinternal control system might represent risks to lenders and investors.These risks could relate to collateral reporting, interim financial reportingor possibly fraud, such as asset misappropriation.

4. In the post-great-recession-e a, investors and venture capitalists arelooking for more information about the viability of their prospects. Anunqualified audit and a management letter free of noted weaknesses giveyou an advantage in seeking funding as it adds another layer of potentialvalidity to your financials and itnernal control methods.

Core RatiosPRIMARY RESERVE RATIO1. The Primary Reserve Ratio measures the financial strength of the institution by comparing expendable net assets to total expenses.

2. Expendable net assets represent those assets that the institution can access quickly and spend to satisfy its debt obligations.

3. This ratio provides a snapshot of financial strength and flexibility by indicating how long the institution could function using its expendable reserves without relying on additional net assets generated by operations.

4. Trend analysis indicates whether an institution has increased its net worth in proportion to the rate of growth in its operating size. The trend of this ratio is important. A negative or decreasing trend over time indicates a weakening financial condition.

Core RatiosPRIMARY RESERVE RATIO CONTINUED

5. It is reasonable to expect expendable net assets to increase atleast in proportion to the rate of growth in operating size. If theydo not, the same dollar amount of expendable net assets willprovide a smaller margin of protection against adversity as theinstitution grows in dollar level of expenses. Source KPMG

6. The Primary Reserve Ratio is calculated as follows: ExpendableNet Assets/ Total Expenses

Core RatiosNET INCOME RATIO1. This ratio indicates whether total operational activities resulted in a surplus or adeficit, answering the question posed in chapter 1, “Do operating results indicate thebusiness is living within available resources?” (mitigating excess burn rate).

2. This ratio is a primary indicator, explaining how the change in unrestricted netassets affects the behavior of the other three core ratios. A large surplus or deficitdirectly impacts the amount of funds an business adds to or subtracts from netassets, thereby affecting the Primary Reserve Ratio, the Return on Net Assets Ratio,and the Viability Ratio.

3. The method provides that a business display a separation between operating andnonoperating activities as this separation presents a more informative display of aninstitution’s operations, ie. Are you lean? Are your initiatives effective?

4. The Net Income Ratio, calculated when an operating indicator is presented, is asfollows:Excess (Deficiency) of Operating Revenues Over Operating Expenses/ TotalOperating Income

Core RatiosRETURN ON NET ASSETS RATIO

1. This ratio determines whether the institution is financially better off thanin previous years by measuring total economic return.

2. A decline in this ratio may be appropriate and even warranted if itreflects a strategy to better fulfill the company’s mission. (ie. We wouldhave increased net assets; however, we built out our new laboratory whichwill increase our production/output going forward).

3. On the other hand, an improving trend in this ratio indicates that thebusiness is increasing its net assets and is likely to be able to set asidefinancial resources to strengthen its future financial flexibility.

4. The Return on Net Assets Ratio is calculated as follows:Change in Net Assets/Total Net Assets

Core Ratios

VIABILITY RATIO

1. The Viability Ratio measures one of the most basic determinants of clearfinancial health: the availability of expendable net assets to cover debtshould the business need to settle its obligations as of the balance sheetdate.

2. The formula for this ratio is: Expendable Net Assets/ Long-Term Debt 3. The numerator is the same as the numerator for the Primary ReserveRatio.

4. The denominator is defined as all amounts borrowed for long-termpurposes from third parties and includes all notes, bonds, and leasespayable that impact the company’s credit, whether or not the obligation ison the balance sheet.

Core RatiosVIABILITY RATIO CONTINUED

5. Although a ratio of 1:1 or greater indicates that, as of the balance sheet date, abusiness has sufficient expendable net assets to satisfy debt obligations, this valueshould not serve as an objective since most businesses and investors would find thisrelationship unacceptable.

6. Analysis of financial statements over the past three fiscal years by KPMG indicatesthat this ratio should fall between 1.25X and 2.00X and higher for the strongestcreditworthy businesses. However, the level that is “right” is company-specific. Theleadership should develop a target for this ratio, and others, that balances itsfinancial, operating, and programmatic objectives.

7. There is no absolute threshold that will indicate whether the company is no longerfinancially viable. However, the Viability Ratio, along with the Primary Reserve Ratiodiscussed earlier, can help define an company’s “margin for error.”

8. As the Viability Ratio’s value falls below 1:1, the company’s ability to respond toadverse conditions from internal resources diminishes, as does its ability to attractcapital from external sources and its flexibility to fund new objectives.

Industry Metrics

The financial statements and the core ratios are auniversal business language; the industryperformance metrics are industry-specific language.

A quick glance at a case example: Retail

Industry Metrics

Comps/comparable-store sales, or same-store sales: measure thechange from year-to-year of a retailer's sales, in a fixed base ofstores, for a given month. Only stores open for at least a year areincluded in the same-store-sales count. This prevents the numberfrom getting distorted by newer stores that generated disparatesales from a company's core average.

Sales per square foot: Sales per square foot is the averagerevenue a retail business creates for every square foot of salesspace.

Inventory Turns (Inventory turnover): The number of times thatyour inventory cycles or turns over per year. Or cost of sales/average inventory= Inventory turnes

Industry Metrics

Conversion: Of the total number of prospects that visit your store,how many actually buy? Measures the proportion of visitors to aretail outlet who make a purchase. Sales transactions/traffic =conversion rate

Customer acquisition cost: (especially important for omnichanneland online retail) cost associated with convincing a consumer tobuy your product or service, including research, marketing, andadvertising costs. What is the value of the customer to thecompany and the resulting return on investment of acquisition. Asan accessory to this, what is the retention cost? (i.e. is shippingkilling you to keep them even at a loss—early Amazon, Wayfairetc.)

Your Assignments!

Now that you know of the basic financial statements expected,search examples of completed statements by businesses in yourindustry, and if you have not already, develop financial statementsfor your business regardless of its stage.

Once you develop your financial statements, you can thencalculate each of the four core ratios. Plan to calculate thesequarterly along with your quarterly financial statements. Theseratios provide a great and widely held barometer of fiscal stabilityand position for growth.

What you can do immediately is search what key performanceindicator metrics are tracked in your specific industry and usethese as a periodic measurement of the efficacy of your day to dayoperations.

Enjoy NOEW 2016!

Thank you and best of success.

ContactA. J. Brigati

504.265.9924888.317.8882

[email protected]

no more smoke and mirrors: knowing and demonstrating business numbers

Small Business & Entrepreneurship