--The Secured Lender: January 2017
When management is effective at exercising control over measurable operating metrics and handles scalability organically, for every dollar of revenue generated in a business a portion will be profit. Without operational controls in place and absent a strategic approach to profitability, the business may not succeed with any longevity, will lose market share, and the lending institution or business owner will be left holding the proverbial bag as the firm declines or worse, defaults.
At any point during the lifecycle of a business, from projection review in loan origination to special assets classification and workout, when lending institutions are performing due diligence on a borrower’s financials, it is prudent to gain stronger understanding of what cost control strategies are being employed by the borrower to arrive at optimal profitability. In doing so, the lender will cultivate better insight into the borrower’s business model, thereby tapping into hidden sources of capital, increasing effective communication, and ultimately minimizing challenges with debt servicing, breach of covenants and potential default.
Benchmarked and anticipated profit margins vary by industry, differ from business to business, and can be razor-thin or the size of a proportionate bubble. However, when a firm is engineered to generate profit in a controlled cost structure, profit becomes a measurable outcome from the operation rather than what is left over after all other expenses have been paid; the business becomes a profitable investment instead of a job purchased by the managing members that is being financed by the lending institution.
How Lending Institutions Benefit from Profit Engineering
Profit engineering is an effective tool that can be utilized for lenders and borrowers during the process of approval in loan origination, when a borrower is going through or emerging from a workout situation, and turnaround situations where the borrower is exiting a bank facility and into an alternative financing source. After performance optimization measures have been executed, a strategic sales and marketing program has been implemented, and profit has been engineered and budgeted along with operating expenses, the lending institution will recognize that the borrower has an active strategy for growth and success, thereby leading the lending institution to more confidence in the borrower’s ability to remain profitable and effectively service the financial commitment.
Profit as the First Line of Expense
To engineer a business for profit, a percentage of the net profit as presented in the income statement is carved out and reapportioned as a payable expense equivalent to note payments, cost of goods to vendors and general, administrative, or operating expenses. Because engineered profit is classified as an expense, it is budgeted through projections and subsequently benchmarked in budget reports.
With a reasonable payables schedule, typically monthly or quarterly, profit distributions of the engineered profit can be executed concurrent with paying other payables, thereby ensuring that a reasonable return on investment is being earned through the performance of the business. If the business is not profitable or is in a workout situation, effective turnaround actions can be executed to identify challenges causing the unprofitability, and in planning the emergence and growth, as projections are being developed and budgets planned, engineering profit becomes part of the restructuring and renewal.
In estimating a reasonable level of engineered profit, rather than determining from arbitrary industry net profit averages, it is best to project reasonable profit goals based on budget projections and attempt to set an engineered profit concurrent with those goals. Once the level is set, the remaining balance of the net profit becomes a retained earning that is re-invested back into the business or eligible for profit distribution at a later date.
Control is Key
For profit engineering to be effective and not cause cash strains, it is imperative that management have an acute awareness of control measures and have tools in place to effectively manage the operation with strict adherence to procedures. If these controls are absent, management is effectively “flying blind” through assumptions and likely has little to no contingency plan when inevitable challenges arise. With effective control measures in place, the organization can grow organically and profitably and avoid a condition of operating from top line growth with unplanned and oftentimes debilitating, expenses.
Tools that can be put in place to help monitor key performance indicators of the business and keep the engineered profit model effective include:
- Revenue Projection: A firm must recognize the revenue required to cross the profit threshold, and with reasonable accuracy, project future revenues. Also, revenue analytics must be measured, including demand forecasting methods and price optimization techniques, to ensure that customer needs and product offerings are aligned and met.
- Variable, Semi-Variable and Fixed Expense Budgeting: Without budgets and strict adherence to budget procedure, profit engineering is effectively useless. Every expense that a business services to remain operable must be placed under strict budget including note payments to lenders. The most rapid way a business spirals into distress is when expenses are not budgeted and capital is ineffectively allocated without reasonably predictable results. It is not uncommon for business owners to spend capital under the pretense that if the additional revenue generated from the expense is greater than the expense itself, then it is a good investment. If budgets have been planned effectively, this lack of budget adherence can translate into uncontrolled costs, and evidence of this style of management should be a red flag to lenders.
- Historical Sales/Costs Analysis and Regression Output: While sales history is not present in a startup, for mature businesses and those with even minimal history, benchmarking future projections against historical data is the most effective management control mechanism for predictive analytics especially for businesses with razor-thin margins. Depending on the type of business, historical data analysis should be reviewed from the yearly, quarterly, monthly and weekly positions, particularly when seasonality applies or the product being sold requires rapid turnover. When used strategically and in conjunction with applicable regression analysis tools, businesses will be able to smooth out shortages and overages to reach optimal performance in expense categories notably labor and inventory.
- Comprehensive Break-Even Analysis (for more insight, Break-Even: Controlling Profitability During the Off-Season): Beyond being the point of balance where revenue is equal to all expenses, in reaching break-even, the profit threshold has been crossed at a point in a calendar year, month, week, day or hour whereupon each additional dollar of revenue becomes pure profit. Strategically managed organizations employ a combination of effective tools to not only increase revenue, but also place focus on lowering the firm’s overall break-even to become more rapidly profitable at an earlier date in the calendar year.
Questions to Consider When Reviewing a Borrowers Profitability
In conjunction with reviewing financial reports, to increase mutual understanding of controlled and potential engineered profit effectiveness with a borrower, several questions should be considered in due diligence:
- How did the firm arrive at projected annual volume? What factors were considered, and are there adjustments for seasonality?
- What volume is required to break-even annually, quarterly, monthly, and weekly? At what point in the calendar year will projected break-even be reached and the profit threshold crossed?
- What are the working capital requirements to keep the business operable, and are working capital reports frequently reviewed?
- How often are financial statements reviewed, and what line item is looked at first?
- What is the current net profit before taxes, and is both a gross and net profit margin strategy being utilized to ensure a healthy bottom-line?
- How are cash requirements projected for the business?
- What is the current operating profit bottom-line, and what does the working budget call for?
- How are operating expenses controlled?
- How often are budgets reviewed for Variable, Semi-Variable and Fixed expenses?
- Are itemized sales reports reviewed, and how often is pricing determined?
While these are only a few questions to consider in a due diligence profitability analysis, they set the stage for arriving at optimal engineered profitability.
No More Questioning if the Business is Going to be Profitable
Without profitability or a reasonable projection to profitability, lending institutions are clearly not incentivized to lend capital to a business. However, simply showing profitability in projections prior to loan origination without cost controls can be a precursor to a borrower that will eventually land in breach of covenants or distress. Likewise, if a borrower emerges from a workout, but the tools to control profitability have not been put in place, there is an elevated chance of falling back into a distress situation in the future. When a business has been engineered for profit, the lender will recognize that the borrower has placed strict control on capital allocation, thereby more safely ensuring that financial obligations will be met as the firm successfully grows.