Financial Fundamentals for Family Businesses: A Simple Guide

Financial capital is the lifeblood of every family enterprise, just like any other business. And to guarantee the progress and longevity of your family business, it is crucial to maintain healthy financial fundamentals over the longer period of time.

But what exactly are these fundamentals, and how can you make sure you are on the right track?

We are aligned on what is most important with Ed Patton, a professional colleague and creator of the Patton Trender® (www.pattontrender.com) concept of making financial trend measures simple & concise to avoid the malaise of too much information. Accordingly, we’ve both broken it down into five key components that are essential for every family business.

Adjusted Operating Earnings Cash Flow: Understanding Your Core Profits

Operating earnings, or operating profit, represent the profits realized from a business’ core operations. This figure isolates earnings generated from the primary business activities, excluding non-operating expenses such as interest payments and taxes. However, it is not operating earnings but rather cash flow from operations that is essential.

Understanding the traditional cash flow statement has always been notoriously difficult for most family business owners and their non-financial managers. Too often these users’ cash flow analysis confuses their understanding of how their decisions related to the non-current accounts are also affecting, sometimes significantly, their business’s financial health.

Adjusted Operating Earnings Cash Flow or the “Foundation Cash Flow™,” as it is referred to in the Patton Trender, includes the operating earnings adjusted for depreciation, interest expense & other gain/loss and/or income, and the period change in long-term debt, capital expenditures & equity accounts. Management’s understanding of the trend in this key measure, both historically and forward-looking, is critical to financial health and future value of the business.

Margins : Assessing Operations Profitability

Gross margin, expressed as a percentage, is calculated by dividing the direct profit from sales ( i.e.- sales less cost of sales) by total revenues. This metric provides a snapshot of the profitability of the sales performance of a company from its core operations. For family businesses, monitoring gross margin trends helps in evaluating sales performance profitability, market pricing power trends and making informed sales decisions.

Basically, simply producing more revenue is not what is important but rather it is selling at a steady or increasing profitability and/or increasing market share.

Operating margin, expressed as a percentage, is calculated by dividing operating earnings by total revenues. This metric provides a snapshot of how efficiently a company is generating profits from its core operations. For family businesses, monitoring operating margin helps in evaluating profitability trends and making informed business decisions.

Basically, operating margin indicates the proportion of revenues left after covering operating costs. It is a crucial measure for both management and external stakeholders – and high variability in operating margins can signal business risk.

But – rising operating margins indicate effective cost management and increasing profits, contributing to the overall financial health of the family business.

Liquidity: Maintaining Financial Flexibility

Liquidity management is crucial for the health and sustainability of any organization, including family businesses. Typically, liquidity simply defines a company’s ability to meet its short-term financial obligations. For family businesses, maintaining adequate liquidity ensures that they can cover unexpected expenses or seize unexpected opportunities as they arise.

So, by necessity, monitoring a key liquidity trend measure recurringly is essential for safeguarding the financial health of your family business. Once again, the “Keep It Simple” doctrine should be applied here too. Accordingly,  it is a simple measure when liquidity is expressed as the single dollar amount resulting from cash and any unused line of credit amount less the total sum of operating costs including loan principal payments, past due payables, tax payments, balloon debt maturities and any distributions required over an agreed future time period (e.g.- 1 month, 3 months, etc.).

Owner Valuation: Understanding Business Worth

Valuing a family business is a crucial step for owners, whether they are thinking of succession or estate planning , or considering a potential sale, or simply assessing the positive or negative impact of their past or future financial management decisions. The owner valuation process involves assessing the economic value of the family business, taking into account factors like assets, earning potential, and market conditions. Understanding the valuation of the business is essential for making informed investment decisions.

Regular valuation assessments using a consistent valuation method can help you ensure alignment with your business’s long-term goals.

Term Debt Capacity: Balancing Risk and Growth

Understanding term debt capacity is essential for family businesses to make informed financing decisions and avoid the risk of default. Term debt capacity simply illustrates the amount of  non-working capital debt a family business can responsibly take on without jeopardizing its financial stability.

Balancing debt levels is crucial for managing risk and facilitating growth opportunities – so understanding your business’ debt capacity helps your leadership make prudent financing decisions and avoid too much leverage.

Several factors influence a company’s term debt capacity, including factors that hinge on industry dynamics, market positioning and competitive advantage.

A best practice is recurring reporting to management of the measurement of term debt capacity to provide guidance toward capital investment decisions for the family business. Term debt capacity can be most simply derived by multiplying  the annual free cash flow less estimated income tax  by a current market loan constant less the total outstanding of any term debt balance of the family business. Thus, a business with $1mln in free cash flow (i.e.- cash flow less maintenance capital costs),  $1mln in existing term debt outstanding  and market loan terms of 8% & a 7-year term ( i.e.- 18.70% loan constant) and a debt coverage ratio of 1.35% should qualify for $3mln in additional term debt for new investment financing.

Key Takeaways

Maintaining healthy financial fundamentals is essential for the long-term success of any family business. By focusing on adjusted operating earnings cash flow, margins, liquidity, owner valuation and debt capacity, family businesses can ensure financial stability, profitability, and resilience in an ever-changing business landscape.

Regular monitoring and strategic planning are key to navigating challenges and seizing opportunities for growth.

Remember, these financial fundamentals serve as a guide, but every family business is unique, requiring tailored financial strategies to thrive. If you need assistance in assessing and managing your family business’s financial health, don’t hesitate to reach out to our team at Ferguson Alliance.

Our team of experienced and trusted family business advisors stands ready to offer personalized guidance that can help your business thrive. Call us today to set up a consultation.

Outside sources:

https://www.pattontrender.com

https://www.financestrategists.com/wealth-management/valuation/family-business-valuation/

https://www.afponline.org/ideas-inspiration/topics/keeping-the-lights-on-the-why-and-how-of-liquidity-management

https://www.wallstreetprep.com/knowledge/debt-capacity/

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