In our many years of working with entrepreneurial clients, it seems that selective listening remains a challenge…even when the advice is expressed in words straight from the mouth of St. Paul.  Our entrepreneurial friends fight the good fight, always.
Some are better at fighting the “bad fight,” or the wrong fight, tragically ending up insolvent or losing their entire investment. But fighting the good fight was only half the message, and this leads me to the entrepreneurial dilemma for right around this corner we find the big opportunity, the big ending, the whole enchilada, the Holy Grail, the very reason we fight the good fight so long and so hard. You see, we don’t hear the better half of the message nearly as clearly as the first part. We often forget that we are also called to “finish the race, strong.”
How can a totally dedicated and passionate owner be confident that he and his company will in fact finish the race strong? By knowing and managing those business vital signs, those critical value (performance) drivers that make the essential difference between finishing the race strong, and maybe not ever finishing at all. More frequently that we would like we encounter business failures which usually could have been prevented with timely interventions.
Why Build Wealth?
After more than a decade in which other forms of investment stole the limelight, business owners are only recently beginning to wake up to the hidden value in their own enterprises, so writes Ray Manganelli, managing director of  the consulting firm, Strategic Decisions Group. In his book Solving the Corporate Value Enigma (Amacom) Manganelli says the average business creates only 60 percent of the value it is capable of creating. Dean Dinas, senior economist for the National Association of Certified Valuation Analysts (NACVA), estimates that only about 5 percent of small businesses have ever had a formal valuation done by a qualified professional. One reason is that entrepreneurs are too busy running their companies to be concerned about the value of those companies. Also, some don't think they need to build or measure the value of their companies unless they plan to sell. Hmmm??? That’s pretty bizarre! Many business owners devotes an entire lifetime to the business with 100+ hour a week routine and years spent traveling or waiting to board an airplane. Worse yet, entire seasons of soccer and basketball games were missed. Time gone will never be recaptured. Even the precious relationship with those we love is sacrificed so that the business might thrive and continue. Why? After all those rush orders, all that pain, all those years, all that sacrifice, was it worth it? Who knows, really? We all have doubts, don’t we?
Yet, after so many years of incredibly hard work, can we be confident that we have built something of value, something that will stand the test of time long after we’ve left the office for the last time? The answer is a resounding YES.!!! We must construct our foundation built of value, creating what is called “A Culture of Performance”.
A Culture of Performance
An effective performance-management culture exists when employees use practical management tools to set targets, measure performance, and implement concrete action plans to meet objectives. To some extent all organizations set targets and monitor results. However, in most distressed companies, strategy and initiatives are not linked. Even if they are, it is rare to find them aligned to the right targets that drive the core value engines of the business.
An entrepreneur who is considering exiting, selling or stepping down from a business may find that his successor needs an entirely different set of skills than the founder possessed. Establishing a new company requires a different skill set than does sustaining or growing a mature business. To maximize value this new tool kit must contain very robust and powerful value-driver performance capability to ensure that ownership confidently knows it is ready to exit the business at just the right time and that its successors will inherit a culture and high-performing executive team, ready and capable of managing the business professionally and independently.    Indicators relating to the absence or insufficiency of a performance-management culture usually include one or more of the following:
A lack of rigor surrounding the cash management process Poor or nonexistent controls in the areas of manufacturing, planning, and procurement No linkage between financial measurements and key performance drivers Lack of accountability within the ranks of management A general lack of focus and ownership of results
Which essential organizational metrics and value signs must be aligned to what? On what shall we focus?
Operating Cash Flow or EBITDA
By now, most of us have heard of EBITDA (Earnings Before Interest Taxes, Depreciation, and Amortization). Generally, this is the short-cut method of measuring operating cash flow. Frequently, we hear financial decision-makers and journalists speak of the value of a company in terms of multiples of EBITDA, stating that this firm sold or was acquired for X times EBITDA. While this rough rule of thumb is a good starting point, a practical question remains. Could you be convinced to plunk down millions of dollars for a business solely on this barometer of a firm’s ability to throw off cash? I didn’t think so, and neither would we. There are many other pieces to the value puzzle, but we have another powerful rule of thumb that provides a sanity check to EBITDA as a barometer of value generating capability.
Excess Cash Margin
Several years ago, a study by the Financial Analysis Lab at the Georgia Institute of Technology's DuPree College of Management, found a troubling gap between cash flow from operations and operating income for the 87 nonfinancial members of the S&P 100. DuPree found that the difference between operating cash flow and income for the median company in the group was almost 12 percent greater than average for the three years that ended in 2002. DuPree called this gap a company's excess cash margin, or ECM. While a small gap of this sort, whether positive or negative,  is not necessarily a troubling sign, a larger positive ECM in double digits reflects a heavy dependence on improvements in working capital and other boosts to cash flow that aren't sustainable, simply because such gains aren't generated by the growth of a company's underlying business operations. Ideally, operating cash flow and earnings should both grow more or less evenly over time. When they don't, and one measure exceeds the other by a large margin, there's reason to doubt that a company's performance is as strong as either measure alone may suggest. Volatility in ECM very well might reflect greater risk. And, in some of these cases, such volatility may also reflect questionable accounting practices as well. What's more, there's a natural gap between operating cash flow and income at any given time, simply because depreciation and amortization are reflected in net income but not in operating cash flow (EBITDA). As a result, companies with small positive gaps between cash and income are likely to be performing better than those with equally small negative ones. Naturally, any gap will be much larger for capital-intensive companies and those with heavy investments in intangibles.  But while the ECM results provide only a snapshot of operating performance, closer scrutiny shows that this metric reflects fundamental strength, or lack thereof. Yet, interpreting the significance of ECM can be challenging. A cyclical company may generate more operating cash flow than operating earnings during a business slowdown as assets and liabilities are liquidated. When business picks up and liquidated accounts are replenished, earnings may grow at a rate faster than operating cash flow. In that case, the two measures are likely to return to relative balance before long. On the other hand, excessive ECM at any given point may instead reflect a change in the stage of a company's life cycle, as the transition from growth to maturity or from maturity to decline alters the relationship between earnings and operating cash flow for good. Regardless of whether changes in ECM reflect business or life cycles, the measure does appear to provide a valuable snapshot of a company's ongoing operating performance. And in the current environment no issue is more critical to building and retaining shareholder value than the degree to which a company's underlying business is or is not expanding. I think that’s what St. Paul was trying to tell us. Be sure to finish the race, strong. Pay attention to the vital signs of those critical value drivers, and if necessary consider getting help.  Since 1998, Tony Wayne has been President of IronHorse LLC, a specialty business & financial services firm with practice specialties in business valuation and appraisal, due diligence and forensic investigations, corporate value recovery, and insolvency advisory services. Tony is a Certified Valuation Analyst, Certified Insolvency & Restructuring Advisor, and Certified Public Accountant. He is an Executive Fellow & MBA from Rockhurst University, and serves as Adjunct Professor of Accounting/Finance at Johnson County Community College and Baker University. <<Click here>> to download a printable copy of this article.