Sustainability of key company metrics essential when prepping for sale

Originally published in The Business News

In preparing a company for a possible sale, business owners have to be aware of the key metrics buyers care about most. Even during the COVID-19 pandemic, these important metrics haven’t changed: earnings before interest, taxes, depreciation and amortization (EBITDA), cost of goods sold (COGS) and cost of sales (COS). What has changed is how buyers will evaluate how a company adapted to a black swan event like the pandemic and whether that adaptation is sustainable to the future success of the business after a sale. Buyers are also paying closer attention to the resiliency of a company’s supply chain.

Improving EBITDA

A stronger EBITDA number will make a company more attractive to a potential buyer. A company can improve its EBITDA two ways: increasing revenue or decreasing operational costs. Studies have shown the same movement of EBITDA will be achieved by a 10% increase in revenues or a 1% decrease in operating costs.

It’s not surprising companies looking to improve this key metric in the short-term focus on costs more than revenue. Buyers, however, will look closely at how a company tries to reduce costs.

Manipulating COGS and COS

Companies can consciously reduce COGS and COS, but each cost also can be affected by events outside of the company’s control. If a company is positioning itself for sale, reducing COGS or COS have similar impacts on EBITDA; buyers, however, are alert to unsustainable changes in either of these metrics.

When a business starts experiencing unexpected movements in its COGS, for example, it indicates to a potential buyer the company does not have the appropriate controls over its supply chain.

A company that tries to improve their numbers three months before a sale will discover that buyers will value the business at a lower multiple, on the assumption that the changes represent a one-time, and not sustainable, savings.

If a seller thinks its valuation is not where it should be, and it can effectively cut costs, the time to make improvements is now, not necessarily for a sale in 2021, but in a preparation for a sale in 2022.

Paying attention to risk

What the pandemic has made clear is that many companies have not paid appropriate attention to risk over the past 30 years, especially when it comes to their supply chains. Part of positioning a company for sale is understanding what those risks are and capitalizing on them.

For the past few decades, up until 2017, China and other Asian countries have benefited from American companies looking for low-cost suppliers. The tariff and trade war disruption to supply chains starting in 2017 convinced many companies to start researching alternatives to China and Asia for key commodities.

The pandemic effectively and suddenly broke these supply lines and highlighted that industries that had shifted their supply chains solely to China and Asia were not prepared when those supply chains shut down.

A seller has to prove it has a resilient supply chain that will survive a black swan event. This means demonstrating it is sourcing goods, not just out of China, but also South America, Latin America or domestically. The company’s EBITDA might reflect the higher costs of a diverse supply chain, but it also demonstrates to a potential buyer the business has a viable defense against an interruption of supplies.

Another way for a company to show resiliency is by pivoting their entire product line, either in response to supply chain interruptions or customer need. In the early weeks of the pandemic some companies shifted their production lines to make various types of personal protection equipment (PPE). For buyers, this ability to pivot demonstrates a company – regardless of what their supply chain or cost basis looks like – is forward thinking and can take effective action.

 Due diligence awareness

The biggest due diligence issue sellers should be aware of is buyers are likely to ignore financial results from 2020 – good or bad. Companies trying to sell in 2021 will discover they will not get the multiplier on EBITDA they are expecting.

A sharp increase in sales may indicate a company had a high-demand product because of the pandemic – for example, PPE, printers or at-home exercise equipment. A sharp decrease in sales may be linked to government-mandated closures in a given area. Dramatic shifts in either revenue or costs may not yield clear insight into the overall health of a business.

To gauge the true value of a company, buyers will likely focus on 2018 and 2019 earnings as a baseline and then the company’s forecasting for 2021 and 2022, regardless of whether the company has focused on generating revenue or cuttings costs. Buyers will also closely examine the quality of the data that supports the forecasting as true indicators of the value and sustainability of a company. 

If a business has the luxury to prepare properly, it can spend 2021 aligning the key metrics noted above, implementing the various initiatives to improve those numbers, and positioning the company appropriately for sale. Intelligent sourcing is a mechanism to protect and grow revenue and to accomplish cost savings, but, just as important, it's a mechanism that will provide comfort to a buyer that a target company’s plan is sustainable.

For more information or to learn how Baker Tilly specialists can help, reach out to your Baker Tilly advisor or contact our team.