“Turnover is vanity, profit is sanity and cash flow is reality.” We’ve all heard it said, but a huge number of people have never taken it in, thought it through or understood it.
From time to time we will do some marketing to get some fresh blood into the network; and as the phone starts to ring, we are quick to recognize the “buyers” who have no real understanding as they ask: “What is the turnover?”
You see it does not matter, as a general rule. Of course there are exceptions like petrol stations and supermarkets, both of which work under a fairly standard set of parameters, understood intimately by their operators.
But when it comes to most businesses which battle from day to day to maximise their sales, while buying in their stock as low as possible, and minimizing their expenses, turnover is limited in relevance to calculating the VAT and commissions, and setting records to be graphed on a wall in the owner’s office, usually behind the door.
When it comes to valuing a business, turnover has no importance at all, except to point us in a direction of the business’s growth, and even this can be misleading. When we value a business, our model draws lots of graphs to identify the places that managers of businesses may be going wrong, and one of the anomalies we often see is a sudden rise in turnover coinciding with a fall in gross profit percentage. The inference to be drawn is that the business owner is “purchasing” sales turnover in order to impress someone, usually a hoped for purchaser of the business.
If things are well planned and fixed expenses are rationalised, this may lead to greater profits, but more often than not, the “sale month” leads to lower profits, and the result is exactly opposite to what was intended: Value falls.
Here is the simple calculation:
Two businesses in different cities, manufacturing the same goods with the same turnover and similar expenses, but one has lower cost of sales because it is closer to its principal suppliers. It has an immediate advantage with stronger cash flows, and after paying the same expenses as its counter part, ends up with more profit.
Given the opportunity and inclination to buy either business, which one would an investor choose? Well the more profitable one of course. And if there were several investors in the same room, there would be a bidding war, and the price would go up, as the less profitable business is ignored.
Does that make sense? Of course it does. Now stop asking about turnover in valuing your business, and concentrate on the net profit and the benefit you really get out of the business as the owner.