A tale of two companies: Success has so many variables, check key metrics
Over the last three years, I have had the opportunity to examine two sets of two companies, each set of which is located in the same geographical area of the country and offers the same security services.
Anyone looking at these four companies (two sets of two) would be struck by what also hit me: how much more financially successful one was than the other despite being in a similar market and offering the same services. The question is, how did this happen and what lessons can we draw?
• All four companies offered the same general security services to the public
• It is true that the two companies operating in each part of the country did not operate in the exact same city — just in the same general area.
• All four companies have been in business a fairly long time — certainly long enough to get themselves established.
• There were no other constraints on any of the four companies as to what they could or could not do.
Here is what strikes you when you look at the financials of the two pairs of companies:
• One company in each location had significantly better looking financials than the other and this was consistent over the last three years (i.e. not just a one-off event).
• Better financials means:
- Better working capital and working capital ratios
- Greater retained earnings
- Significantly better Net Income and Net Income to sales ratios
- Significantly better EBITDA and EBITDA to sales ratios
It is more difficult to compare these small companies on items like gross margins and expense ratios because different companies include different items in their calculations of each. Also each company’s owners paid themselves using different methods (salary versus dividends) and different amounts.
However it is important to note that the four items that we singled out above of Working Capital, Retained Earnings, Net Income and EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) are all very important — if not the most important — measures that others will value your company by.
It is also interesting that in both cases all these four items showed much better in one company than the other, not just one or two of the items. Allow me to provide some suggested targets for each:
The ratio of total current assets to total current liabilities should be at least 1.5 to one. Two to one is even better. It is many times the case that a company that has a good working capital ratio has good financials elsewhere as well.
There is no one ratio here to measure yourself by because different owners keep various amounts of money in the company. . Suffice to say that buyers like to see companies with significant retained earnings left in the company. This usually indicates that the owner is trying to build the company.
Net Income and Net Income to sales
To get to these ratios properly, you have to “normalize” your earnings for “Owners Take” and any other extraordinary revenue or expense items. To normalize for Owners Take, adjust your earnings to what you would have to pay a General Manager to run your company. Having done both of these steps, that if you can consistently generate 10 per cent of sales in Net Income before Taxes, you are doing well.
With most security companies, EBITDA and Net Income numbers are not that far off each other because there are not usually significant fixed assets producing yearly depreciation nor is interest expense likely to be a big item. When I talk to buyers about EBITDA ratios, I hear numbers like 15 per cent as being attractive. Check your EBITDA calculation and see how you are doing.
EBITDA ratio of 15 per cent would be more applicable to an integrator than to an alarm company where the value is determined more by the recurring monthly revenue of the alarm accounts.
The bigger question is why two companies functioning in the same market offering the same services can end up with such different financial results? I have some plausible answers:
• One company just functioned much more efficiently than the other. Sales per employee were greater for one than the other. This is a very important measure and a measure we all should pay attention to.
• One company paid its employees considerably more than the other in the same market.
• One company’s margins were greater than the other: 40% and above compared to 30% when fully comparing “apples to apples.”
I know most security dealers cannot obtain comparative numbers but it is worth checking your key numbers and seeing what you can do to improve them.
February 27-28, 2018