Profit100 companies are ranked by the size of their increment in profits based on their last 2 years of accounts filed. This provides a consistent and easily comparable dataset. If those companies want to leverage their performance through fundraising or sales, we at Cavendish know that this reported performance is just the starting point.
Reported profits are essentially a view of the company through the rear-view mirror. Generally, the time required to audit a business means that 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 interval will be reduced but not completely eliminated.
The truth is that no one buys a business for the profit it has made because it belongs to the last owner. The classic small print on investment advertising – “Past performance is no guarantee of future results” – is appropriate here. So how does one get guidance on the profitability of a buyer and how best to anchor those negotiations to the highest possible number for the seller?
The best way to think about it is as a two-pronged problem. The first objective is to attract the buyer to the future profit number. Note that at the growth rate for all companies in the Profit 100, this would be a larger number than the current profit.
You may think that if the reported performance is not a good standard, you should refer to the current year’s business budget. The fact is that most businesses set their budgets at the beginning of the year – commission driven sales teams usually insist on this! – and they get old fast.
An updated forecast for the year addresses this issue but will still include months of actual performance earlier in the year that are a rear-view mirror problem in miniature. Take a facilities management business that signs several large new client contracts halfway through its year. These wins will be forecast in the second half of the year, but any buyer will be reaping the benefits for the entire year. In these examples, we value the business based on its run rate ie the monthly performance is multiplied by 12 to represent the full year’s profit.
The other dimension is what counts as profitability and the figures re-reported here can undersell the business. The buyer is not inheriting the owner’s historical costs if it does not need to be replaced. The founders’ drawing (which often includes family members’ payroll and other expenses) can be added back to the profit per accounts.
But there are likely to be other costs that have reduced profits in the past but will not affect the future: writing off a large bad loan, recruiting fees or start-up costs to a key new hire, and startup losses. A new branch or area. Keeping in mind the dual purpose is to provide more accurate guidance for the future profitability of a growing business and to anchor investment or sales discussions around higher numbers, all of which increase profitability. There should be side adjustments.
A year-on-year increase in reported profits in your annual accounts is a great achievement for any business owner and sets a great foundation when negotiating a deal for the company. However to maximize value one needs to look at the current and future levels of profitability for the company.