Firm managers run a production process. If the deliverables get out the door, great. If not, cash flow – and company value – could be harmed.
Over my career, I have had some disappointed clients. I am not talking about the disappointment you feel from realizing you ordered the wrong entrée at dinner. I am talking about the disappointment you feel when you realize your firm is worth much less than you expected.
Most owners look back and wish they had focused on increasing revenue, improving margins, or cutting costs, when they really should have been focused on improving cash flow. Why is this important, you may ask? The fact is buyers, and great investors, focus on free cash flow – cash flow less capital expenditures. Free cash flow drives your value far greater than any other metric – period, full stop, drop mic.
At this point you may be confused because you may be under the impression that the value of your firm is derived from EBITDA. The answer is no, EBITDA is simply a proxy for deriving value because calculating free cash flow requires a little work and people are lazy, at least when it comes to corporate finance. Put simply, your value is the sum of your future free cash flow divided by a capitalization rate. After all is said and done, the free cash flow method is what matters the most. Firms all across the economic spectrum that have focused their management efforts on it have generated wealth well beyond their peers.
The mindset of an owner that contemplates the power of free cash flow is they focus on getting paid; more specifically, getting paid faster. I am not simply talking about getting your clients to pay more quickly; I am talking about focusing on increasing the speed at which you turn your firm’s efforts into cash. This mindset leads you to be more efficient in how you deploy your firm’s resources, and constantly strive to increase the efficiency at which you do your work.
Architects and engineers live in a world of professional service, which deludes them into thinking that they are detached from the world that is occupied by purveyors of tangible goods. Wrong! Let me tell you, it’s no different. Think about your architecture or engineering firm as a factory that produces concrete anchors. Your architects and engineers are the machines that produce the anchors and the projects are the anchors themselves. The longer the machines take to create the anchors, the more work in process you have on hand. As sales grow, you have to invest more cash into anchors that are being made, money that could be spent elsewhere. As revenue increases, your A/R grows and more of your money is tied up as a client’s IOU rather than as cash in the bank. Conversely, the faster you produce anchors, WIP decreases and cash flow increases. It is not just factories that work this way; this applies to an AEC firm.
It is frankly easier for a factory manager to look out at her factory floor and see problems. Physical product that is stacking up, orders languishing on the factory floor, and cramped warehouse space. Managers of AEC firms have no such physical indicators; they need to create systems to warn themselves of issues. When times are lean, banks force firms to become efficient by limiting credit; however, when times are good credit is used as a crutch, masking the fact effort is not being turned into cash.
This is not just for looking at your administrative functions; it is really for business planning and decision-making. Could you imagine GM or Boeing budgeting for next year without any consideration for the capacity of their factories? I cannot, but architects and engineers do it every year.
“How much more revenue did we have last year? $10 million? Great, how about $12 million this year. Next item on the agenda, corporate holiday cards.”
No thought or consideration is given to how you produce the projects that generate the revenue. You can kill your cash flow by haphazardly adding work. Plan your production process poorly – congratulations, you killed your firm’s value by increasing revenue. You think I am kidding, but I am not.
The fact of the matter is that this is conceptually easy, but hard in practice. You may not be able to work faster like our anchor example, though you may have plenty of waste in your firm that can be dumped to increase the speed in which you convert effort into cash. Focusing on cash flow requires you to change how you think about which projects to pursue, how to do work, how to bill – essentially the entire business. Managers of AEC firms ultimately run a production process. Ignore the factory at your own peril.
Hobson Hogan is an investment banker and consultant with Continuum Advisory Group. He can be reached at email@example.com.