ACHRNEWS

Lessons Learned In Bankruptcy

March 4, 2004
[Editor's note: This is the first installment of a multi-part series on the realities of bankruptcy from a first-person point of view. In this installment, Mark Roberts recounts his experience running an HVAC contracting firm, stressing that business owners must calculate the company's true rate of return.]

Last year, I had the misfortune of placing a 25-year-old family HVAC company into Chapter 7 bankruptcy liquidation. If you have never experienced this, let me say that you never want to. It is a stressful, emotional, and embarrassing procedure that results in the knowledge that you not only let down your customers, employees, and suppliers, but, most importantly, you let down yourself.

Let me begin with a little background. I grew up in the HVAC business. My grandfather had a successful (yet often stressful) HVAC business. My uncle had his own HVAC business, which also went bankrupt. Another uncle has been employed in the industry for most of his life and is now considering self-employment in the HVAC industry. My father had his own HVAC business, which is where my story begins.

I grew up helping my dad in his business on weekends and during summer breaks and holidays. As most of you who have been in this business for many years can relate, when times were good, they were very good, and when times were bad, they were very bad. I saw my dad go from having a shop with several employees in good times to working out of the house by himself in tough times.

At the age of 21, while I was on summer break from college and helping my dad on a job, I noticed something was very wrong with him. He had bloodshot eyes and seemed sick. The next morning I had to rush him to the hospital. He was suffering from a massive stroke.

My dad survived his stroke, and for the next year I learned more about life and business than any college course could ever teach me. I quickly learned to sell, install, and service HVAC systems. While lying in his hospital bed, my dad would write out wiring diagrams for me with the hand that he still had control over. I learned service through real on-the-job training.

I can remember blowing out thermostats (direct short) right on the wall and trying to figure out how in the hell to wire in fan center controls and relays, something that now seems relatively simple.

Mark A. Roberts

A Taste Of Success

My dad eventually recovered enough to hire a few employees and run the business again. I finished college with a degree in finance (which I admit, in retrospect, left me with little real knowledge of finance). After a one-year stint as a stockbroker, I rejoined my dad, to his delight. We had a vision to build a highly successful HVAC company.

In 1996 we got right to work on growing the company. My dad ran the operations, and I went to work on sales. We worked hard, and things really took off. We brought in new customers, began to spend advertising dollars (poorly, in retrospect), and added employees. As the economy heated up, we soon outgrew our house operations and moved into a leased facility. Everything seemed great. Sales had gone from $250,000 a year to $1 million within three years.

The truth is, everything wasn't as great as it appeared. While we had converted from paper accounting to a computer program, we really didn't grasp the financials. It seemed funny that we showed a profit on the books, but there was never any real money to show for it. We were also beginning to take on debt with new trucks and the need to cover an ever-increasing payroll in a tight labor market when cash was tight.

Then, seemingly overnight, the bottom fell out. The economy slowed, and sales dropped off. Our annual sales goal was $1.3 million, but our sales topped out at $820,000. We had suffered an approximate $60,000 loss on the bottom line, which I later discovered that my dad covered by taking on credit card debt.

Struggling To Stay Afloat

To compound matters, my dad passed away the following year, and we suffered another $9,000 loss due to an inability to cancel fixed contract expenses during a period of sliding sales.

I spent the next two years trying to turn the business around. My pricing was often too high due to excessive overhead and debt leverage. Suppliers were soon placing me on "cash only" status, and meeting payroll became a constant struggle. When my landlord asked for my personal guarantee, in place of my dad's, to re-up our lease, I realized that the game would soon be over.

Our business failed for the same reason most businesses fail. It was not due to a lack of effort, but rather the lack of solid financial planning. Simply put, our business failed because of poor management.

In the two years that I spent trying to fix the troubled business, I resolved never to put myself in that position again. I love the challenges that come with business ownership, but financial ignorance would never again be a reason for failure.

I awoke every morning at 5:30 during those two years and began studying financial analysis coursework. I am now working towards a designation as a professional financial analyst, and perhaps the most relevant and useful information came from my experience operating my own business.

I am amazed how little the consultants who put on the seminars that I attended over the years actually knew when it came to teaching business strategy and finance. While much of the information provided by these people was very helpful, it was often apparent that the seminar leader lacked real knowledge about financial planning and business strategy.

Their mantra of "grow, grow, grow" - which our company followed - can come with a cost. For our company, this unmanaged growth contributed to our demise.

My experience in the business of contracting has left me with many good memories of the times I spent with my father. However, our lack of financial skill resulted in a family legacy coming to a dismal end.

With this series of articles, I hope to help you to avoid the fate of our family business.

Link Strategy To Financial Planning

What does the word "strategy" mean? The dictionary defines it as "the skill of planning to defeat an enemy." A better definition in relation to business would be to manage sales, expenses, and assets in such a way that your company achieves its financial goals. So, strategy can be broken down into two main functions:

1. Effective planning.

2. Successful execution of the plans.

But what are your company's financial goals? Most small-business owners would answer "to make a lot of money," or "to make a profit of x percent." But what is the right profit for your business? If you answer the higher the percentage the better, you may be wrong. A higher profit on your income statement can be misleading in some cases.

I used to listen to consultants rave on about how this industry's average profit margin is only between 2 percent to 4 percent of sales. They would then go on to say that with such low profit margins, "contractors would be better off putting their money in the bank." This shows a lack of understanding about business financial planning. While it is true that the industry average net profit margin does run between 2 percent and 4 percent of sales, this is not how you interpret the "return" on your business. An analysis of most industries with sales under $4 million will uncover that such a return on sales is not uncommon.

Figure 1. The formula for determining average total assets.

Your Company's True Rate Of Return

To determine the real return that your business earns, you will need three documents:

1. Income statement (P&L).

2. Balance sheet (beginning and year ending).

3. Cash flow statement.

Most small businesses do not create a cash flow statement, which will be discussed in more depth in future installments of this series. For this analysis, you should now have your income statement and balance sheet (which you should review monthly) in front of you.

Strategic planning for your business should always begin with what is called "return on investment" (ROI). For the sake of this discussion, we will use "return on investment" and "return on assets" (ROA) interchangeably.

If you were to invest your money in an investment instrument outside of your business, what kind of a return on your money would you look for?

If we go one step further, what kind of return on your money would you look for if you invested your money in a company with risks similar to those your business faces on a daily basis? Most small-business investors (also known as venture capitalists or "angel investors") would not consider an investment if it would not earn them at least 25 percent on their money.

Now ask yourself, how much money do you have tied up in your business? This can be found by looking at your balance sheet. Look at the row that is labeled "total assets." This row should be found right underneath "accumulated depreciation." (You are depreciating your assets and setting up a depreciation savings account, aren't you?) Your total assets give you a pretty accurate picture of how much money is invested in your business by you and your creditors.

Assume that your business has $125,000 in total assets at the beginning of the year and $175,000 in total assets at the end of the year, equaling $150,000 in average total assets for the entire year. (See Figure 1.) Consider year-end sales to be $800,000 - a realistic ratio of sales to total assets in the HVAC industry. Let's further assume that your operating income, found at the bottom of your income statement before deducting interest expenses and taxes, equals 4 percent of sales, or $32,000.

Your company's before tax ROI equals 21 percent. (See Figure 2.) While this may not be a great return considering the risks your small business takes, it is a much better return than placing your money in the bank.

Figure 2. The formula for determining return on investment and sample calculations.

What's A Good ROI For Your Business?

When deciding on what ROI goal your business will aim for, you need to consider your company's capital structure. What is capital structure? Capital structure is the term used to describe the sources you use to finance your company's assets/operations.

Capital can come from many sources, but most small businesses can be broken down into two entities.

1. Equity Financing

  • Owner's personal investment in the company.

  • Outside investors' personal investment in the company.

  • Reinvestment from company profits.

    2. Debt Financing

  • Bank loans.

  • Credit card financing.

  • Certain leases.

    The way in which you choose to balance these two forms of financing will determine your company's capital structure and will play a role in the required ROI that your company must earn. It will also play a crucial role in the potential risks and rewards that your business faces.

    A note on figuring out your ROI: If your company has long-term leases on vehicles, the vehicles may not show up as assets/

    liabilities on your balance sheet (this is referred to as "off balance sheet financing").

    If you are obligated to a term structure of the lease arrangement, then you should consider the fair value of your vehicles as assets when figuring ROI (interest expense can be figured by phoning your lease company). You want an accurate picture of the return you are earning on the resources utilized vs. the true liabilities and risks taken by the company and its investors. Your company must earn a return on investment that meets or exceeds the costs of financing the business.

    Figure 3. A sample calculation for determining the weighted average cost of the company’s capital investment.

    A Hypothetical Case

    What are the costs of financing your business? Let's look at

    a hypothetical example. Assume the following capital structure for a fictional heating and cooling company:

  • $80,000 in bank loans for the purchase of vehicles with an interest rate charged by the bank of 6 percent.

  • $20,000 in credit card debt with an interest rate of 16 percent (annualized).

  • $100,000 in owner's equity investment.

    The owner desires a rate of return of 30 percent based upon the risks he takes investing in the company and considering alternate investment opportunities of similar risk.

    The weighted average cost of financing the business is figured as follows:

  • $200,000 total capital investment in the business.

  • Equity at 30 percent equals 50 percent of the company's capital investment.

  • Bank debt at 6 percent equals 40 percent of the company's capital investment.

  • Credit card debt at 16 percent equals 10 percent of the company's capital investment.

    Therefore, the weighted average costs of capital financing equals 19 percent. (See Figure 3.)

    The company must earn a minimum of 19 percent tax adjusted ROI to satisfy the costs of its capital structure. The effects of tax policies, such as the ability to write off interest payments on debt have not been considered in the above example, and would further re-duce the cost of capital. While this specific example would imply that the company should utilize as much debt as possible to lower its cost of capital financing requirements, this is a double-edged sword, and will be discussed in more depth in future installments when we evaluate company risk.

    In the above example, the company must earn a minimum 19 percent return on its $200,000 capital investment or an operating profit of $38,000 for the year. If this company has annual sales of $800,000, then its minimum operating profit margin (return on sales) would equal 4.75 percent. This profit margin would satisfy the costs of debt financing and provide ownership with a 30 percent before tax return on its $100,000 capital investment.

    Note that the ownership return is subject to corporate taxation and should be adjusted respectively based upon your company's tax rate and ownership's desired after tax rate of return. Also, be aware that repayment of bank loans that are not offset by depreciation expensing will affect the required ROI.

    Remember, your ROI must be greater than or equal to your company's cost of capital (financing).

    Next week: Creating a strategic plan for your company based on your ROI.

    Roberts is owner of Roberts Commercial Lending Co. LLC. He provides corporate finance and debt consulting, business loans, and leasing services. He can be reached at 586-716-8329 or CommercialFnnc@aol.com.

    Publication date: 03/08/2004