Edition 230 – Hidden Profit: Hidden Value
No financial statements that I have ever viewed in my 30 plus year career highlight the most significant item inside any family business. It’s a huge number that impacts:
- The profitability of any business.
- The goodwill valuation of any business.
However, because it is hidden, it’s not recorded. When it’s not recorded, it’s not understood. So, today, it’s time to understand the true impact of hidden profit.
Every family business has excess capacity. Whether it is labour that is under-utilised, warehouse space that sits empty, or a production line that operates a single 8 hour shift (but could run 24 hours), the numbers are staggering.
Let’s try this with an example of a Professional Services Firm.
- 5 practitioners.
- Annual Revenues of $1 million.
- Chargeable hours per week expressed as a percentage of total available hours – 65%
- Desired chargeable hours per week expressed as a percentage of total available hours – 80% (NB – it’ll rarely be 100% unless you expect administration tasks and toilet breaks to happen out of hours!).
- Assuming $1 million of revenue is generated at 65% productivity – that means you have total available revenue capacity of $1.538 million (i.e. $1 million divided by 65%)
- If you’re aiming for 80% chargeable hours, that means your desired revenue capacity is $1.230 million (i.e. $1.538 million x 80%).
- Excess Capacity = $230 000
Now, the issue with this is that your family business could, potentially, generate an additional $230 000 in revenue without a single additional dollar of cost. That means, the additional revenue will drop straight to the bottom line as pure profit. That’s why it’s called hidden profit.
Depending on the business and its cost structure, its my experience this hidden profit could increase the actual net profit of a business by anywhere from 1 to 4 times.
It’s why most accountants get it wrong when they try and maximise profit by minimising expenses. In my 30 plus years of working with family businesses, never have I seen expenses reduced to the point where it will improve the net profit by 1 to 4 times the existing result.
There’s another impact to consider in terms of identifying hidden profit – and that is how it impacts Goodwill in a family business.
Goodwill is, in essence, a function of the net profit generated by a business. It is often between 2 and 5 times the adjusted annual net profit of a business and is one of the key factor in terms of valuing a business. The variable that you choose depends on a number of factors including:
- The industry your business operates in.
- Its future potential.
- Its past performance.
- Its ability to systemise.
- Its management structure.
- Where it sits in the business life cycle – i.e. mature or new entrant or in-between.
In our simple example above, increasing revenues by $230 000 could increase the goodwill valuation of the business by anywhere between:
- $460 000 – at 2 times; and,
- $1.15 million – at 5 times.
The phenomenal thing about this is that, if the $230 000 profit improvement is anywhere between 1 to 4 times the existing profit result, it means that goodwill could increase from anywhere between:
- From $115 000 to $575 000 – at 2 times
- From $287 500 to $1.437 million – at 5 times.
In our example, hidden value in this family business could be between $460 000 and $1.15 million – an extraordinary number given the likely current valuation of the business.
It’s why, even when times are tough, if you focus on maximising revenues rather than minimising costs, you can create significant differences in the financial position of the family business and the wealth of the family shareholders.
This Week’s Tip
If I’ve blown your head with these numbers, give me a call. You’d be surprised where you can find hidden profit and hidden value inside a family business.