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How to grow cash and equity for more financial security: The cigar box approach
March 10, 2008
Hank Salvo, Partner, Scion Advisors
Let’s face it -- owning your own business is about having the freedom to make choices and to take risk at your own pace. Winery owners today are increasingly concerned about how to get to financial security so they have more freedom and more options for the future.
Many are asking how they can:
− Drive a high performing business that can fund a change in family ownership
− Weather poor economic cycles with less at risk
− Create a business asset that is worth more and that can fund retirement
− Fund growth from a comfortable balance of debt and cash
This article lays out some of the groundwork you need to accomplish so you can be more successful at making choices and taking risk in order to reap the returns of your hard work.
The cigar box approach
Many years ago a sage old boss told me to run a business like you have a cigar box on your desk. Cash from what you sell goes into the box. Cash for what you buy goes out of the box. At the end of the day, whatever cash is left in the box is your profit for the day.
Sounds easy. However, cash flow is very difficult to forecast because of the many factors that impact it and the timing of all those factors. For example, the length of time finished and unfinished wine sits in inventory before it can be sold; after it’s sold, the length of time it takes you to get paid; the timing of grower payments; the timing of packaging costs.
Why cash flow is important for family businesses
There are many examples of why cash flow is important for family businesses: it allows you to fund business expansion without adding more debt; to pay down debt; to fund the addition and growth of family members into the business; to buy out stakeholders when necessary or to pay dividends to existing stakeholders so they can build their own cash reserves and independence from the family business. And, it can fund estate taxes.
Sound cash management tells you to minimize the lag time in receiving cash and to delay disbursements as long as legally possible. This is tough to do in the asset intense wine industry where it may take years before you get a decent crop that sells for a decent price. If you are not a virtual business, you’re probably sitting on land, some of which is producing and some of which is not. You may have a winery built for future growth, growth that has not yet translated into profits. This over capacity was likely funded through debt which requires cash to support it.
Therefore it always makes sense to treat your business as if you are going to sell it, whether that is the case or not, because this philosophy encourages you to implement sound practices that will help you manage cash flow and maximize your business’ value. Ultimately the value or equity in your business is the present value of all the future cash flows the business generates and those future cash flows are just as important to a potential buyer as to your family.
Defining success and cash flow targets
To really get clear on how your cash flow can perform around your business, you should have an idea of what you want your business to look like when it reaches its potential. If you don’t have that yet, I suggest some scenario planning exercises.
Your ultimate goal is to increase cash flow and, thereby, your equity and company value. From our experience with wineries in California, if you’re in the $25-50 price segment, building cash at 35% of revenues is a good target; for a product portfolio in the $50-100 price segment 40% is a good performance level.
Understanding and maximizing cash flow using EBIT
Recognizing the difficulty of calculating and forecasting cash, you will need a cash flow formula that works for your business. To keep calculations simple you will need a surrogate for cash flow; we would use some form of operating income, probably EBIT (Earnings Before Interest and Taxes). It’s not perfect but nothing is.
Here are some ideas on improving your EBIT:
1. Maximize channel distribution. Margins are much higher in your wine club and direct to consumer business (DTC) so growth in these areas will lead to higher gross margins, growth in EBIT, and less dependence on the trade. If you’re in the $25-50 segment, a gross margin of 60% is a good target. For $50-100, 70% is a good target.
Click here to see an example of how Scenario Planning can help you explore building EBIT (our surrogate for cash flow, as discussed below) in your business.
2. Understand your expenses. Normally, I would say Sales, General & Administrative expense should be no more than 25-30% of your revenues. However, in today’s competitive environment, let’s peg your operating expenses at 30-35%. What expenses do you really need to run your business? Are business trips planned efficiently to maximize you time and exposure? Are wine samples in control? Do you need expensive bottled water in your tasting room when a pitcher of tap water would do? Everything adds up. Since marketing agencies charge 25-30% of revenue for their services, this again highlights the need for a healthy wine club and DTC business.
3. Utilizing capacity. If your winery is not operating at its capacity, can you contract pack someone else’s wine without compromising your own brand until growth catches up to capacity? This can be a complementary brand to maximize the production timing or even a competitive varietal from a different price segment. Or, can you lease out the excess space? If you are building your winery, can you build it in stages to match growth and minimize cash outlays? Do you really need all the land you have to reach your goals? This is one of the toughest questions in any agricultural business. No one wants to sell land but unused land creates debt with no return.
Understand your rate of return by varietal
Besides knowing your Return on Capital for the company, it is helpful for you to understand which varietals are pulling their weight and which are not. The notion of Return on Capital is not as daunting as it sounds – the formulas we describe below employ typical fiscal metrics.
Rate of Return by Varietal = varietal NOPAT / Capital Employed per varietal
1. EBIT. To separate profitability by varietal, calculate sales revenue and cost of sales for the varietal. Whichever expenses are not obviously attributed to one varietal can be allocated on a percent of revenue or effort basis.
2. Taxes. The tax rate used would be the standard rate whether you are actually paying taxes at this point or not.
3. NOPAT. Net Operating Profit After Taxes is simply EBIT less taxes.
4. Capital Employed. This is a combination of all of the direct and indirect assets attributed to a varietal. You already know which vineyards support which varietal; excess land can be allocated based on volume; the winery can be based on usage. All assets should be net of amortization and depreciation.
5. Return on Capital. This calculation should yield at least an 8% percent return and hopefully closer to 10%. You probably will not be there in your growth years, but you’ll have an idea of which varietals are doing well, which need work, and perhaps which need to be eliminated. This calculation should be done on today’s numbers, but can also be done on the last year of your long range plan to verify improvement.
Also, if you want to get an idea of what your excess assets are costing you, such as unused capacity or land, run the same calculation as the varietals without allocating any of these unused assets. This will give you an idea of your varietal performance in a more perfect environment, where you’re using everything to its maximum capacity. You can of course also use this Return on Capital calculation for your company in its entirety, not just by varietal.
Conclusion
There are no magic bullets in managing and improving your cash flow. Despite being a great lifestyle and fun business, you already know that the wine industry is tough. However, having a sound understanding of just how your business is built and knowing your strengths and weaknesses will improve your financial security and give you more freedom to spend time with your family and friends. Remember, mind that cigar box.
Preparing your business to transition to its next phase of growth should include thorough discussions with your family about your goals and how these can be supported by your business assets. Before you develop a plan you will need to clarify your exit strategy. This requires answering the question: do you eventually want to sell the business to a 3rd party or your kids? You should also consider running alternative scenarios for building a business that is worth more. For that reason, you may find it beneficial to bring in outside advisors with a broad wine industry perspective and proven experience in family businesses planning. That’s how Scion can help. At Scion we work alongside wine business leaders with an approach that guides you through your planning process to produce more effective strategies that drive improved profitability and brand equity and make the most sense for your family business.
Copyright 2008 Scion Advisors DBA. All rights reserved.
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