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Examine your GPMs over time

I have recently found it’s a relatively common experience among people my age (I’m 66) to ask, “What did my dad look like when he was the age I am today?” Most of us, I’m sure, look in the mirror after finding the appropriate photo and say, “Hmm, I’m not doing so bad! I’ve clearly got many more good years and miles left in me!”

The reason I’m thinking along these lines is that it’s equally instructive (if not as sentimental) to do the same with your business’ financial performance. For example, we had a client a while back who had really consistent gross profit margins (GPMs), year-in and year-out, with incremental improvement over time, as one would expect from a well- run operation. But, there was one clunker year in the mix.

Hypothetically, let’s say their GPMs were running at 30%, then 31%, then dropping to 24%, and rising back up to 32% and 33% over a five-year period. Any acquirer is going to look at that business and ask, “Why did you drop to that 24% gross profit margin in that one bad year? That’s quite a drop! Can you explain it?” Chances are, you can explain it, as painful as the memory may be.

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A drop in GPM like that from 31% to 24%—a negative 22.5% change—can happen for a number of reasons. A common one is that you got caught in a contract where you bid a large customer, or a series of large jobs, on the assumption that you’d buy the required materials at or around the price at the time of your initial bid. Especially a couple of years ago, that was a risky assumption. Lumber prices were fluctuating, often reaching to all-time highs. Other costs, for items such as windows and millwork, were equally unpredictable. Even though it may have made you cringe when those customers called to say, “OK, ship that order you bid three months ago,” you very likely honored the bid price, ate the loss, and saw your GPM drop as a result.

Going back to how I opened this column, what if you were to take the GPM you have now, and apply it—just as a mathematical exercise—to see what your business would have looked like without the one-time hit that so negatively affected your margin? Go to your summary income statement (assuming the Excel spreadsheet is set up using formulas), delete the 24% and apply your most recent GPM of 33%. Now, look at your new resulting earnings before interest, taxes, depreciation, and amortization (EBITDA). It jumped. If only managing a business in real life were this easy! You have essentially remodeled that sales year when you got whacked, and you are now looking at it through the lens of your company’s subsequent better performance. If you are not selling your company, this exercise of swapping out GPMs is nothing more than a curiosity.

However, if you were selling your company, this exercise would be a crucial one. Here’s why: Departures from otherwise consistent performance of your KPIs need to be explained to a potential acquirer. When seeking an acquirer, it’s universally better to do this while preparing your deal for the market; make the explanation an element of the deal book. There’s a snazzy term for this approach, “premortem,” where you predict questions before you’re asked. Work with your investment banker to show what the GPM would have been if not for that one bad event. Write a narrative to explain it. This will show what the EBITDA would have been if the GPM were normalized, or averaged over a period of years that excluded that glitchy 24% year.

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Will acquirers understand and accept this? Well, most acquirers of LBM-related businesses certainly will. Those acquirers won’t be surprised that you got on the wrong side of a trade. They’ve probably seen it before in their portfolio companies. They will also probably be impressed that you honored your bid price and ate the loss, all in service of building customer loyalty.

Finally, keep that old photo of your dad at 66 on your desk, to remind yourself how gosh-darn good looking you are today.

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