May 08, 2012

Time To Sell: Fundamentals

Take a look at my five year forecast for this business (click here to contact me for your own five year forecast).

This is a business that has stalled.  It's not terribly profitable, is it?

Last year, this business generated $93 million in demand, $79 million in net sales, and a paltry $2.3 million in earnings before taxes.

If you were going to sell this business today, what could you fetch for it?  Ten million?  Less?

The forecast isn't very optimistic, is it?  Demand is stalled, customer counts are flat, and profit is being eroded by fixed costs that are increasing at an inflationary rate.

Now, I know this is boring to talk about, but fundamentals are really, really important.

Net Sales represent the percentage of what a customer asks to purchase that the customer actually keeps.  Say you sell 100 units.  You can only fill 95 of them because five sizes aren't available.  And of the 95 that remain, 10 are returned for a refund.  You net out at 85 units sold.  Your Net Sales rate, therefore, is 85/100 = 85%.

It turns out that if you are able to make a small difference on the Net Sales line, you make a big difference on the Earnings Before Taxes line.  Take a peek at what happens when the Net Sales rate changes, from 85% to 88%.

Well, the profit and loss statement looks better, doesn't it?  That tiny three point increase in the Net Sales rate resulted in more than a million dollars of additional profit, per year, for each of the next five years.  If a business like this sells at five times earnings (and it may sell for much less, but please bear with me), then, you've just improved the value of the business from $10,000,000 to $15,000,000 ... because you've improved the fundamentals of the business.

Gross Margin represents what you get to keep, after accounting for Cost of Goods Sold.  If you sell an item for $100, and you paid $45 for that item, then you get to keep $55 ... your Gross Margin is $55/$100 = 55%.

Gross Margin is frequently influenced by the ability of a business to accurately forecast demand.  When customer demand is weak, liquidation of existing items is required.  Liquidation of merchandise, if you didn't already know, kills Gross Margin dollars.

It's not uncommon for a business, within just a year of time, to improve Gross Margin by three points simply by focusing on inventory management.  Take a look at what happens when we combine a Net Sales improvement with a Gross Margin improvement:

Oh boy!  A business that was generating about $2,000,000 of annual profit is not, through a strong focus on fundamentals, generating about $6,000,000 profit.  At five times earnings (and this business might now fetch more, given that the health is starting to improve), this business might be worth $30,000,000.

In other words, the business may be worth three times as much (maybe more) by simply focusing on the fundamentals ... accurately forecasting demand, filling orders, and eliminating returns.

I know, this isn't sexy stuff.  It's terribly boring.  You won't get re-tweeted on Twitter talking about the fundamentals of a business.  And yet, management of the fundamentals makes all the difference, doesn't it?

Tomorrow, we're going to talk about merchandise productivity.  Hint --- merchandise productivity matters!

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