I’ve seen some pretty interesting accounting lately. Clients come to us for all sorts of professional advice and we normally try to establish the financial health of their business as part of the process. I usually start with the question: ‘Are you making a profit?’. Most of the time the answer is positive. When we look at their books we sometimes get a nasty surprise.
Two recent examples come to mind. Both clients approached us to see if we could help sell their businesses; which were small cafes operated by husband and wife teams. They were both showing around 10% nett profit on their books, on around $500,000 turnover. This immediately made me suspicious because in my experience, it is difficult to make a reasonable profit from this type of business in this volume band.
More often they just make wages for their owners. The books of both showed unusually low wage percentages so I proceeded to ask questions to establish the real situation: ‘Are you showing your own wages on the books?’ ‘No.’ they answered in both cases. Now, you don’t have to be Einstein to work out what was going on here. They had to live, and in both cases they had a reasonable lifestyle so the money had to be coming from somewhere . . . if you get my drift.
Your business worth is established from your ‘official’ income
The problem for us is when you go to sell a business you can only sell what shows ‘officially’ on the books. In these cases I had to tell the potential sellers that to sell their businesses, their books would have to be adjusted to reflect a realistic level of wages. This would wipe out the book profits they were showing, kill the potential value of the businesses and make both families liable to a rather large income tax bill.
The other issue that was present in both businesses was the lack of accruals in the accounting system to put aside money for renovation and refurbishment. All hospitality businesses need regular makeovers and irregular major renovations. The money to do this has to come from somewhere. If money has been steadily put aside for this purpose, then it is there when it is needed and forms a positive entry in the balance sheet.
Have you been putting money aside for refurbishment?
If it has not been saved it will have to be borrowed or injected into the business from other sources and becomes a liability. The lack of accrued funds for refurbishment detracts significantly from the value of an otherwise saleable business — especially if it is a bit run down.
The underlying issue here is the relationship between short term profits, or operating profits as they are called, and long term profit, which we call capital gain. Operating profit is the money you make on the turnover through your business. Put simply, you trade for a week, pay all your bills and what is left is operating profit.
Capital gain is the profit you make when you sell a business. It can be a considerable windfall if the right factors are present.
Understand the difference between operating profit and capital gain
Many hospitality operators do not understand the interrelationship between operating profit and capital gain (read: short term vs long term profit). They take money out of their businesses that should be left in it (ie the refurbishment fund), call it ‘profit’ and fool themselves that they are making money. To my mind, what they are really doing is robbing their own future.
Pulling black money out of a business is, in my opinion, doing the same thing. For a start if you don’t keep proper books you have no proper control — and this is likely to cost you as much as you gain. More important than that you are robbing yourself of a potentially large lump of money at the time when you sell your business — so it’s a net loss all round.
You’ll also rob your future if you don’t spend the money to structure your business properly and set-up proper systems of management and control. The most valuable businesses are those that run themselves and don’t require an owner to be present full time.
The availability of modern computer accounting software has made the structuring of business accounts an issue of our times. A lot of business operators set up their own accounts with very little input from an accountant who has proper industry expertise, and then maintain their own books from that point on.
If the business operator has set up their accounts on the basis of incorrect or incomplete assumptions and has missed accounting for critical issues in the business, invariably something will suffer in the future. The most likely thing to suffer will be the ultimate value of the business at the time it is offered for sale.
A properly structured hospitality business should deliver both a reasonable operating profit and the promise of a healthy lump sum when it comes time to sell it. At present there are thousands of restaurants and cafes for sale around the country that are not worth much more than their physical assets would fetch in a fire sale auction — mainly for the reasons I have described.
I know it’s difficult to resist the temptation to pocket and enjoy the money when it’s there, staring you in the face, but what you think is profit may be better put aside than spent.