Written by Andrew Rice, CPA, CVA, Managing Director of Trout CPA’s Transaction Advisory Services
Over the years, I have sat in many management and year-end board meetings to discuss the performance and overall health of the company. My observation is that the controllers and CFOs in the room spend far too much time discussing the bottom line (net income). This is not meant to disparage the finance function; after all, many owners have trained their management teams to communicate and explain the financial results through the lens of net income. (EBITDA or free-cash-flow is a much better bottom-line data point than net income, but we’ll save that discussion for another day).
Here’s the rub. When business owners start measuring the company’s success based on the bottom line, they might fall into the trap of stagnation.
Let’s put some numbers into this discussion.
- Company ABC has grown revenue from $10mm to $12mm over the last two years. During that same period, the net income increased from $2mm to $3mm.
- ABC’s competitor, Company XYZ, has grown revenue from $10mm to $20mm over the last two years. However, XYZ has only seen its net income grow from $2mm to $3mm, despite the significant top line growth.
- ABC has better margins but significantly less revenue growth than XYZ.
What’s my point? Company ABC is treading water. Sure, it is treading profitable water, but it’s treading nonetheless. Many owners run an ABC-type of company. It’s efficient, they’ll say. Tight control of expenses. Healthy margins. What’s so impressive about XYZ? ABC is generating the same margin on nearly half the revenue – they must be inefficient.
This might be controversial in some circles, but managing expenses is – dare I say – the easy work. Any accountant worth their salt can take a red pen to an itemized P&L and trim expenses. (You will not be popular around the office, however).
So, what is the hard work, you ask? Revenue. This is where the best-in-class companies are engaging in deep analysis. Depending on the industry, a bevy of KPIs might be used to monitor customer count, average order size, reoccurrence, churn, return on advertising spend, price sensitivity, and many other data points that bring clarity to the top line.
It is far easier to turn a high-growth revenue business profitable than trying to scale a stagnate, albeit profitable, company. In the case of the latter, these types of businesses typically have underinvested in marketing, capital equipment, and talented employees. In avoiding these costs, the inherent savings has made the business very profitable, but it has removed all gas in the tank for future growth.
In the case of an M&A transaction, you will frequently hear buyers refer to risks around “G&A debt.” This is lingo for general and administrative debt. Essentially, when you’re reviewing the G&A section of the income statement, it might become apparent that the company is significantly underinvested in its infrastructure. When a buyer comes along, this “debt” represents a future investment that will be required to grow the business. Many owners have consciously decided to operate this way, and this article is not an indictment of that decision. Some folks just don’t want to grow anymore, and that’s okay. They make good money. Their employees are happy. All is well.
Unfortunately, this management style doesn’t bode well in the long term, and two events frequently bring it to a head. At some point, keeping the status quo starts to erode the business. It might be a slow drip, but before you know it, the business is in real trouble. The other triggering event might occur when an owner decides it’s time to sell. This can be eye-opening. Using our illustration above, if you’ve been running an ABC-type of company, it’s been a pretty nice ride as it concerns cash flow. During a transaction, however, buyers start asking a lot of questions about the lack of revenue growth. Why haven’t you been able to add new customers? What is your go-to-market strategy? How sensitive are your customers to price increases? If we wanted to double the revenue, how much additional G&A costs would we need to invest in order to service the increased volume? On and on it goes.
Don’t interpret this article to mean that margins don’t matter. They absolutely do. But if the business isn’t growing and the sales engine isn’t getting attention, it might be a matter of time before the company runs out of gas.
If you feel like you don’t know where to start, please complete the form below to speak with a member of our Advisory group. We would welcome the chance to discuss actionable steps that can help clarify your go-to-market strategy through the use of KPIs, data analytics, and best practices.