Among the blasted…

And then, when a year has past, and we – with our sharp planning methods, trimmed machines, skilled employees and a whole laundry boiling with eagerness to perform – meet with the company’s book-keepers and accountants and their ledgers, chart of accounts, balance sheets, working capital, calculators, and…

 

Well, sometimes you just feel like screaming. What good are they? How do the accounts contribute to a company’s achievements? When did an opening balance, a budget, monthly statements or a transaction journal produce anything, apart from stacks of paper?

 

They don’t. They are history. At worst we make them for the tax authorities’ sake. At best they are a kind of time-delayed mirror, reflecting decisions made somewhere else, long ago.
And yet. What is it all worth in a limited economy, if we are not able to substantiate our decisions financially?

Whether we like or not, we are taking an exam – all the time. Each and every day has to be justified. Each and every decision. As a principle the accounts follow us everywhere, all the time, and run through every project, in the short, as well as in the long term. They force us to never act emotionally, never let considerations for the individual overshadow considerations for the collective, never to involve personal preferences.

They force us, in due time and with due diligence, to analyse, conclude, develop, implement and monitor – do whatever it takes. They force us to look at the laundry as if we where the owners. The investors. Buyers.

Then let me do just that – put planning techniques into a broader, financial context, and look at why planning techniques, more than any other technique, are able to improve the laundry’s real values and help it achieve its financial goals.

 

Real Economic Increase, REI
The method is the same, whether we want to measure our management team’s ability to run the laundry, develop incentive salary policies, find the right price of the laundry, perform an operational due diligence, authenticate a business plan, quantify a business idea, identify partners or acquisition targets, or understand the company’s own cost drivers.

The method is Real Economic Increase, REI.

Real Economic Increase is a version of residual income and residual income valuation, a well established financial concept, which dates back to Alfred Marshall in 1890, but has only recently, almost a century later, been applied in business plans and for assessing performance in corporate finance under the name and Stern Stewart & Co. trademark EVA – Economic Value Added.

On the other hand growth assessments are now used in the biggest and most well run companies worldwide, such as Coca Cola, Siemens, AT&T and Quaker Oats. And only few other methods are, to the same extent, able to identify a company’s true capability and values.

All it does is to estimate whether the company, on its present course, is able to survive and compensate the owners in the long run.

 

It is quite…
Easy to calculate in practice. Real Economic Increase is the company’s net earnings before interest, taxes, depreciation and dividends, plus write offs and interests based on the entire company’s expected re-acquisition value and lifetime. So the real increase is what is left, when the company has:

•  paid its lenders a market competetive interest, and
•  renewed the entire laundry and its equipment at market prices.

You may wonder why interest and depreciations from the accounts are replaced by other, computed values.

We do it because interests and depreciations in the accounts are aimed, not at representing real values, but at fulfilling taxation purposes and respecting accounting legislation, and neither helps us appreciate the demands made on the laundry in the future.

If we are to appraise the:

•  company’s ability to survive,
•  alternative investments, and the
•  laundry’s value as a going concern,

– we have to use real values and stake real claims to returns.

 

The example
A midsize Scandinavian laundry invested in new facilities and equipment in the mid-70’s, with a steep fall in labour, water and chemical consumptions as a result. In the following years the laundry experienced a surge in profits, which the owners took out as dividends for personal use.

But at the same time the competition grew tougher and started eating the profits. In the mid-90’s, as the equipment was fully depreciated, profits were gone. Each year since then, the laundry has reported a deficit in accounts without depreciations, and has been forced to mortgage the company assets to continue the operation. Debts ran up.

Today the laundry finds itself in a situation with a 30-year-old production equipment, holding together with the outermost layer of the lacquer, and debts, which has been spent on deficits and salary to the owner. Prices are rock bottom. There is no working capital, no cash flow, no room in the accounts for depreciations and interest on reinvestments. Without having decided it, they painted themselves into a corner.

But why? And when did it go awry?

When they neglected the demand to survive. When they thought they made profits, because it said so in the accounts. When they took that profit out.

It’s so easy. And you don’t see the consequences right away. Only in time. So why worry now?
Because they hit so much harder, when the do hit.

Had the owners instead, year by year, calculated the laundry’s real economic increase, and only taken this out (if anything), maybe the laundry today would have had the necessary working capital to reinvest from.

They would certainly have had the chance to understand what was about to happen, and react to it.

They would have seen it coming – the laundry’s loss of survival capacity. And would have had to leave the profits in the company, go through all the calculations to identify problematic products, customers or processes, and bring the laundry back on track. In time.

 

Everything is not okay
There is no getting round it. If the laundry is supposed to survive in the long run, it also has to create real value. Everything else is beating round the bushes and bad excuses.
It is not enough to have the accounts show a profit. The accounts follow legislation, which is framed by the authorities to fulfil political purposes. We cannot use the annual accounts to evaluate a company’s survival capacity and real values.

Only through the calculation of the real economic increase are the owners, lenders, investors and managers able to judge if the laundry is producing results allowing it to survive, to pay back capital investments, and measure up to alternative capital placements

Instead of telling ourselves that everything is okay, just because we are making profits in the annual accounts, we need to face reality.

 

Destroying values
Yes, it’s damned hard. Unless a company is able to generate a profit larger than the real capital cost, it is making a deficit. It doesn’t create values. It destroys them. A single year with profits does not make a profitable enterprise. Profits in the annual accounts without depreciations or interests are not profits. Paying taxes is, in this context, without any real significance.

Only when the company results are evaluated in the long run, and satisfy the interest demands, do we know if it is well managed.

And no, of course it is not, in the long run, necessary to create real economic increase every single year. Not if there is a point to the deviation. But on average we have to.

And everyday is a chance to do just that. History doesn’t count. Only from today and on.

 

Pull the plug
There are situations when the products are so alike, the competition so hard, and the technical development so slow, that prices have sucked out earnings of all players in the industry. We need to be able to identify enterprises and markets suffering from this phenomenon.

And they do exist – in old, mature industries, where no consumption reductions are to be found in new technology to pay for write offs on new investments, and where the players, in their struggle to survive, have given in on both profit and working capital.

Tourism is, in some places, a good example of this. A destination, like Mallorca, flourishes, people crowd in. First the few and rich, those who can afford coming, also when the journey there is expensive and exchange rates are not at their best.

Later on the crowds pour in, those on monkey class. The destination is worn down and end up with a clientele who bawls, ravage, vandalize and is hyper sensitive to exchange rates, economic conditions, the weather, soccer championships, the Olympics, and all the other things, the individual hotel does not have any influence on.
So what are you to do, if that really happens?

Change market focus – towards niche or virgin markets – if possible. Or pull out the plug, when you have run out of remedies and you are sure the condition is permanent.

If it is clear that you are not going to produce a positive economic growth in your market – not even when the production is trimmed, rationalized and optimized, when all calculations have been checked, when all side markets, synergies and market forms have been exploited – there is usually no other solution than to pull out of the market.

In the end: Sell the company (to somebody who does not know real economic increase), and put your money into something else.

Enter the industry again, when new technology, methods, needs, markets, prices, or changes in the structures or other conditions have re-establish profitability. It may sound tough, but in a tough financial reality, those are the terms.

The alternative is the bleeder syndrome – a slow, painful, suffocating death caused by bleeding working capital.

The laundry industry is, in some places, actually also an example, with fierce competition and no new technologies or techniques to base a continued market development on.

 

Valuation
And since survival capacity is earning potential, REI is one of the most important tools for pricing a company you intend to acquire or merge, and continue to operate as a going concern – as opposed to acquisitions you intend to liquidate and sell off in parts, which calls for other pricing procedures.

But it cannot stand alone in the due diligence process.

Due diligence is risk management. It is the level of judgement, care, prudence, determination and activity that a company need to do prior to an acquisition or a merger. Its purpose is to identify hidden potentials and any unusual and deal-breaking exposures to financial loss arising from markets, products, people, methods, property, obligations & rights, insurance, synergies, etc.

And all areas of the company are examined: Fiscal, legal, technical, operational, organizational, environmental and market related – preferably before the negotiators sit down at the table. Negotiations without a concrete, objective basis tend to be based on intuition, prejudice, personal needs or sheer volume, rather than the consideration for the companies and the assets involved.

Potentials and risks crucial to the continuing company’s future value may be hidden, in organizational structures or operation methods, in procurement, sales or administration procedures, but also in buildings, land, machines, distribution, staff, management, licenses, customers, consolidation etc.

But because of its delicacy it is usually not practicable to exchange this privileged information between the negotiating parts, who every so often are also competitors in the market – or to allow either part to investigate as deep into the counterpart, as a thorough evaluation require. So most often due diligence is best carried out by an industry familiar third party, trusted and respected by the negotiators on both sides.

Due diligence involves simple, practical methods for establishing each area’s influence on the laundry’s value (e.g. grass root surveys), but they are a little out of this article series’ scope, so let us get back to the…

 

Laundry’s everyday life
When the laundry invests, the REI-method force it to look at the investment’s influence on, not only the initial expenditure or depreciations, but on the cost of the entire operation.
But this applies not only to investments. All decisions in the laundry concerning cost driving activities, whether they are entered in the accounts as write offs or operating costs, whether they cause effects in the long or the short term, have to be assessed on their aggregate influence on the operation’s total costs.

Also decisions concerning machine trimming, education and training, purchase of computers, development of new products, process route choices, entering new markets, starting new production lots, etc.

Real Economic Increase only takes this principle one step further.

 

REI and planning
And then we arrive at my point in this article: The REI-method promotes and favours actions with positive bottom line impact without requiring further capital tie-up. It encourages us to concentrate on all the things we can do to reduce costs and capital tie-up, and increase earnings, turnover ratios and cash flow, without further investments.

But how do you do that?
We know that now. Methods. By means of planning, coordination and synchronization. Systematic control and management of production, distribution and stocks. Limitation of all flow-neutral activities, such as administration and red-tape. Maximization of market access and sales. Tight calculations on all customers, products and services. Debtor management. Operating-cost driven procurement.

First of all we must terminate the accident. Tape up the open veins. By means of culture, instructions or management get in control of all actions in the company and orientate each and every one in the same direction – towards the bottom line and real economical increase.

Only then, we should start looking for technical solutions to our problems.

Secondly the REI-method favours investments with positive impact on the operating cash flow, i.e. on:

• cash receipts (e.g. by increasing volumes, processing degrees, or product pricing), or
• cash payments (e.g. by means of consumption reductions, lower cost prices, reduced waste, higher process speeds or reduced stocks).

 

Step-by-step
The Real Economical Increase, REI, is calculated like this:

  • calculate the net result of the company before interest, tax, depreciations and amortisations (EBITDA)
  • calculate the capital tied up in buildings, productions equipment, cars, work capital, research & development and education. And note: equipment investments have to be taken up to the present replacement values (PRV)
  • calculate proper write offs (PWO) of the replacements values for the time in which every asset is expected to be used
  • determine a competitive interest rate (CIR) for the placement of the capital
  • calculate the real economic increase (REI) as:

REI = EBITDA – PWO – (PRV x CIR).

You should only rest when the REI-value is positive. Only then you should take out dividends, and only take out the REI, not the profit in the accounts.

If you do not generate a positive REI-value, first of all apply calculations, techniques and methods, which do not require further investments. Focus on the total variable costs. Plan, rationalize, optimize – maybe using some of the techniques and methods presented in my previous articles. Check all calculations and contribution margins, product-by-product and customer-by-customer. If necessary weed out the bad ones. Get back on track.
Even if it is in the nick of time.

 

Pricing the laundry
And then we also know how to price the laundry objectively: By means of reverse calculations. By back tracking from concrete, achieved and representative results. By using the EBITDA plus interest and dividends, plus depreciations, corrected for the risks taken revealed in the due diligence process, as an annuity which has to cover both principal and market competitive interest. And from this annuity we are able to calculate the principle – the laundry’s market value as a going concern, had it been free of debts and with a full technical and economical lifetime ahead of it.

But this is not enough. This doesn’t necessarily allow the new owners to survive in the long run. To do that, they need to produce a positive REI (e.g. by means of operation improvements, product development, changed market forms, etc.). Otherwise the new owners have bought themselves a bleeder syndrome.

It’s just not fair to work out the laundry value this way, many laundries say – especially those with performance problems. We paid more when we bought it. Book values are greater than this calculated value. Man, the machines alone cost more.

That may be so. But if there no longer is a market for the laundry’s products and services, if the laundry hasn’t been able to produce a profit for a number of years, what is it worth as a going concern?

The potential is there, for sure – some sellers would say.

You mean to say that the new owners are probably better at running the laundry, and the price should reflect this fact? Perhaps, but what claim do you have on their skills?
Try imagine the opposite situation: You have been running the laundry with great success, and then sell to a person, who has absolutely no idea of how to run the operation – would you sell cheap?

We don’t need to argue – some lucky sellers would say – we have others, who are willing to pay the price.

Of course. Other buyers may urge you to consider paying for expected earnings (including your own skills and synergies). But still you have to keep in mind that within short you must generate a positive real economic increase in the continuing enterprise, based on the entire operation’s state of repair, remaining lifetime and reacquisition values.

So, depending on the demand situation, the laundry’s commercial value should be based on an annuity somewhere between the two extremes:

• achieved results (earnings before interest, taxes, depreciation and amortization, EBITDA), and
• expected results (expexted earnings before interest, taxes, depreciation and amortization, EBITDA)

– corrected taking risks uncovered in the due diligence process into consideration.

This is the laundry operation’s market value, had it been free of debts and with a full technical and economical lifetime ahead of it. Then you have to reduce this value to the value of the residual weighted average liftetime of the entire operation, and deduct quantified debts taken over at their actual interest rate or the market interest rate, which ever is the higher.