The ‘Good Business Equation’

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The ‘Business Equation’ is a formula that accountants have been familiar with for many years, using it to map out the relationship of financial activities within a business and ensure they are delivering maximum value.

But could SME owners be using a concept we call the ‘Good Business Equation’ to focus on driving business performance?

Businesses are constantly considering ways to improve profitability, however, knowing where to start can be the biggest hurdle for many SME owners. To assist in this process, Menzies has developed the ‘Good Business Equation’. This simple, visual concept encourages SMEs to consider more than just profit when regarding the value of the business – it also shows the impact that risk can ultimately have on a valuation. Therefore, working hard to mitigate business risks – coupled with an increase in profits over time – could improve buyer or investor confidence.

The value of most SMEs can be based on the following equation: business value = maintainable profits x a risk multiple (for the seller – the higher the better!). When applying this equation, if a business could even slightly increase its profits whilst reducing its risk, the indicative value would increase drastically.

The ‘Good Business Equation’ is balanced, with both sides contributing to the overall valuation of the business. Whilst the equation itself is a relatively straightforward concept, getting the most out of it requires strategic vision and planning.

For growing businesses, the key to capitalising on the ‘Good Business Equation’ is to understand the value of the business as it stands. This information makes it easier to contextualise the impact that specific improvements would have on business value, and consequently, the concept of profitability becomes more tangible.

Business owners should start by obtaining and interpreting the key data, which, for example, could be sales and profitability by product or service, or by customer. In some cases, the data could be used to inform decisions about where and how to invest, and whether to stop selling individual products or services altogether. The results may come as a surprise!

When targeting areas for improvement within a business plan, it is important to build on existing areas of profit potential. Often, it is far easier to adapt products and services in order to target a gap in an existing customer’s market, than it is to win a new client. Therefore, it is crucial to assess the existing market and develop products accordingly.

By cross-referencing existing products and services with the primary customer base, businesses can identify targeted opportunities to tailor their offering, increasing sales and profitability. These ‘easy wins’ could be the first phase of the company’s growth strategy.

With a clearer view of their existing business valuation and what a potential valuation may look like (following a sustained period of growth and risk reduction), SME owners can establish a vision for tactical growth and work toward this in a targeted strategic fashion.

For example, the key to managing workload and securing new business is to make these priorities the responsibility of the wider team. When aiming to increase profitability, and ultimately business value, the responsibility for delivering the strategic goals should be shared among key managers with their progress tracked and appraised.

Whilst profit is a key element in the equation, reducing risk to increase the value of a business is also important and can be achieved in a variety of ways. Investments can be made to improve technology or systems in order to futureproof the business and protect market share – they can also ensure that customers and suppliers are well-spread, with no over-reliance on one key business. However, with growth comes added financial responsibility.

Consequently, there may be a need to improve financial management skills internally or else consider outsourcing this function altogether. Having robust and useful management information, the ability to understand Key Performance Indicators by business unit and access to forecasts are crucial when forward-looking.

For SMEs, invoicing on a timely basis and having strong credit control can help to minimise cash-flow issues whilst maintaining a good client relationship – both of which could help to secure a sustainable future.

In addition to managing the key elements of profitability and risk in the equation, people and the power of data can also have a significant influence on the value of the business. In particular, the presence of an experienced and highly-skilled management team is likely to make a business more attractive to a potential purchaser, in comparison to a business which is controlled by a single person.

For SME owners looking to boost the value of their business, having a sound knowledge of the ‘Good Business Equation’ and appreciating the impact risk has along with profit opportunities is key.

Setting aside time to evaluate financial management data in this way will help to ensure the business is capable of achieving sustainable growth. In the event of a sale or an equity-based investment, it can also help the business owner to leverage maximum value from the deal.

Phil Wright is a director in the FD services team at accountancy firm, Menzies LLP