Profiting from growth

The ability of a business to make growing profits year on year is an undoubted stamp of quality.  Given the turmoil and shocks in the world in recent years – COVID, war, supply chain disruption – it takes not only a well-run business, but one with resilience, to deliver bottom line performance on an upward trend.

The Profit100 companies are ranked here by the size of their step up in profits based on their last 2 years’ filed accounts.  This provides a consistent and readily comparable dataset.  If those companies look to capitalise on their performance through a fundraising or sale, we know at Cavendish that this reported performance will only be the starting point.

Reported profitability is necessarily a view of a company through the rear-view mirror.  Typically, the time needed to audit a business means most private companies file their accounts at or close to the statutory limit of 9 months.  Even looking at unaudited management accounts does not solve the problem; the time lag will be shorter but not eliminated completely.

The truth is no one buys a business for the profits it has made as those belong to the last owner.  The classic small print on investment adverts – “past performance is no guarantee of future results” - is pertinent here.  So how to get a guide to the profits the buyer will acquire and how best for a seller to anchor those negotiations on the highest possible number?

The best way to think about this is as a two-dimensional problem.  The first objective is to get the buyer looking to a future profit number. Remember that for all the companies on the growth trajectory of those in the Profit100, that will be a bigger number than the current profits.

You may think that if reported performance is not a good benchmark then you should turn to the budget of the business for the current year.  The reality is that most businesses set their budget at the start of the year – commission driven sales teams typically insist on it! – and they fall out-of-date quickly.

An up-to-date forecast for the year solves this problem but will still include months of actual performance early in the year which are the rear-view mirror problem in miniature.  Take a facilities management business which signs up several major new client contracts halfway through its year.  These wins will be in the forecast for the second half of the year, but any buyer will be getting the full year benefit.  In these instances, we look to value the business based on its run rate i.e. the monthly performance multiplied by 12 to represent a full year of profits.

The second dimension is what counts as profits and here again reported figures can undersell the business.  A buyer is not inheriting the historical costs of the owner if it does not need to replace them.  Founders’ drawings (which often include family members on payroll and other costs) can be added back to the profit figure per the accounts.

But there will likely be other costs which have reduced profits in the past but will not affect the future: writing off a major bad debt, recruitment fees to a head-hunter for a significant new hire or the start up costs and initial losses of opening a new branch or territory.  Remembering the twin aim is to give a more accurate guide to the future profits of a growing business and to anchor negotiations for investment or sale around a higher number, all of these should be upward adjustments to profits.

Growing reported profits in your annual accounts year on year is a major achievement for any business owner and when negotiating a transaction for the company, sets an excellent baseline. However in order to maximise value one needs to look forward to current and future levels of profitability for the company.