As I looked back on the first year of running my first business I was proud of the profit I had made. I had worked hard to overcome numerous obstacles, and now my year-end revenue was more than my expenses.
I eagerly shared the news with one of my customers who was a successful, multi-millionaire entrepreneur.
He said, “David, how much did you make at your engineering job the year before you started your fight training business?”
“$60,000,” I responded.
“How much profit did you make in your business this year?”
“50,000”
“You haven’t made $50,000. You’ve lost $10,000”
At first, I accused him of not comparing apples to apples and being too utilitarian. But then my heart sank. I was paying myself with distributions and so the profit my business made was my entire compensation. And it was less than I had made before. Not only would my accountant later re-classify a portion of this profit as salary for tax purposes, but I had a serious economic value problem with my business.
Today I find myself repeating this story over and over with the companies we work with at Emerge Dynamics. The numbers are much larger, but the lesson is the same. We’ve worked with companies with hundreds of employees and nine figures of revenue whose owners aren’t getting the full picture of their return on their investment because of distortions in their financial statements.
In smaller companies, these distortions often show up as owners paying themselves less than a market rate. There are certainly intangible benefits to working for yourself that might make someone be ok with less compensation and those shouldn’t be ignored. However, if we are operating a business we think is profitable but is actually benefiting from our free labor, then we are deluding ourselves and will be hit with a harsh reality when we try to sell it one day.
In many larger companies, we see owners compensating themselves more than what a market rate might be. In this case we need to add the excess compensation back to net income in order to get a true picture of the economic value of the business. These adjustments get significantly more complex when larger companies are made up of various related entities. Owners may be paying themselves more out of one entity and less out of another. Or they may own the real estate the business operates in or own one company that supplies another through related company transactions - and all of this may or may not be at market rates. Or they may have taken advantage of accelerated depreciation that isn’t representative of the economic value of their assets. All of this can lead to a financial analysis that tells the wrong story. The return on investments owners have made gets distorted and decision making about what entity to invest in next or what to shut down or sell can be completely misinformed.
The range of possible distortions in financial statements is large and many are more insidious than the examples here. And many remain in place even after financial statements are audited. Accounting standards are different than valuation or economic value standards.
When we begin a financial analysis of a company, a large segment of our effort is un-distorting the financial statements. If we start with distorted financial statements, then all the sophisticated analysis in the world won’t lead to more informed management decisions.
So, before you look at your bottom line and let that number make you want to either celebrate or crawl into a hole, be sure you take a hard look at what made up that number. Are all your numbers made up of actual costs? Or are they possibly distorted because you own the business and have the ability to set certain costs or prices as you wish? While it can take a while to properly un-distort all of these things, just be aware of them and doing a back-of-the-envelope calculation can get you started in the right direction.