When I think about it, which is not too often, I realize that people in business live in a fictional world.
Many of the numbers that bankers base their lending decisions on are backward-looking constructs that follow accounting rules that are almost meaningless in the actual functioning of a business. Inventory, depreciation, and earnings are meaningful yet meaningless artifacts in the real world that are supposed to show value. As most business owners will admit, with inventory lingering on their shelves, and capital equipment aging ungracefully on the shop floor, the values on the year-end report have little to do with their actual value.
On the other hand, an old lift truck or rumbling overhead crane, which might have no value on the books but are used everyday, may have tremendous importance in running a business. Inventory, which will likely never sell, may be carried on the books for a fortune, but probably should be scrapped. The bosses need to show value to justify their loans.
When I look at my own books at the end of the year, I have to ask my accountant, who plays by the dumb rules because he thinks he has to, to tell me what is really important. In other words, did we really make any money, not fictional money?
In recent years, I have been involved in selling several viable businesses. Usually the crucial number for both buyer and seller is the previous year’s EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation.
I have come to learn that from an income generating point of view the term has limited meaning, but it is the number that the lender, who usually puts up all or most of the money to buy the business, considers to be the holy grail. For the buyer, it is the number he or she will use for depreciation, which will have an enormous effect on the future income taxes to be paid.
The irony is that the parties in the deal know EBITDA is a fiction as far as predicting the future income-producing capability of the business. That will be determined by the people who will run the business. Are they good managers? Do they have people skills?
Are the people at the top creative? Can they retain their customers and find new ones? Are the key people ready to retire or walk away? If the boss is retiring, is that a good thing or the company’s death knell?
Yet for buyer, seller, and lender, it is EBITDA that often makes or kills a deal and usually determines the pricing.
If accounting is useless for small businesses, I can only guess how phony it is for big public companies, yet stock prices are often dictated by price to earnings ratios. The earnings are affected by thousands of little lies in huge corporations.
Maybe the fictions balance out over time. Or perhaps they multiply.
Question: What would you like me to write about next year?