What Is A Manufacturer?
Manufacturers transform raw materials into finished products. The conversion of raw materials into finished products adds value (increasing the price of the finished product) for which the manufacturer is compensated. The more specialized and efficient the manufacturer, then the more value will be added. Examples of manufacturers are found in the chemical industry, textile industry, packaged goods industry, and food and beverage industry. Manufacturers generally use large amounts of equipment and specialized labor while selling to distributors or commercial customers (rather than retail customers). Some manufacturers mass produce items and have a high degree of economies of scale, while others focus on making specialized products such as metal working or leather goods.
Evaluate Manufacturing Business
The first steps in selling a manufacturing business includes hiring a business broker with experience selling manufacturing companies, obtaining a clean set of financial records for the past three years, and creating a physical asset list. Evaluating a manufacturer begins by identifying its competitive advantage, or how it manufactures products for a lower cost or a higher quality than its competitors. The more specialized and unique its equipment, manufacturing processes, and skilled labor force, then the stronger its competitive advantage. If a manufacturer lacks a distinct competitive advantage then it generally lacks pricing power and the ability to differentiate itself from the competition. The key metric used to gauge the competitive advantage of a manufacturer is its gross margin. The gross margin of a manufacturer is its gross profit divided by its gross sales. Gross profit refers to gross sales minus the Cost Of Goods Sold (COGS), where COGS is the direct cost of production in materials and labor.
Manufacturers are Capital Intensive
Manufacturers must be evaluated in the context of its overall business structure including the working capital needed to run the business. Working capital refers to cash, accounts receivable (money owed to the business from customers), and inventory (amount of raw materials or finished goods on hand). Many manufacturers extend credit to their customers following industry norms. This in turn may create a large amount of accounts receivable and cash needed to fund operations before cash is actually received from customers. Further, manufacturers often need to carry a high amount of inventory in order to meet anticipated production orders. This adds to the capital needs of the business which lowers the Return on Investment (ROI) for buyers of manufacturing companies.
Valuing Manufacturers
The capital intensive needs of a manufacturing company are ultimately reflected in its adjusted owner benefit. The adjusted owner benefit is the true economic profit derived by the owner, and should be calculated on a cash-basis (where gross sales are only recognized when cash is received). Further, the adjusted owner benefit of manufacturers includes costs of procuring inventory and raw materials needed to produce finished goods. If a manufacturer has a large amount of accounts receivable and inventory, the adjusted owner benefit calculated on a cash-basis will reflect this reality. Typical manufacturers are valued at 2-4 x its annual adjusted owner benefit, with inventory sold separately and account receivables sometimes retained by the seller.
Calculating Adjusted Owner Benefit of Manufacturers
In order to properly value a manufacturing business, its adjusted owner benefit must be properly determined. To start, the EBITDA (Earnings Before Interest, Depreciation, and Amortization) of the manufacturer will appear from its most recent annual financial statement (such as a tax return). The EBITDA represents the pre-tax income without including any costs for depreciation (a non-cash charge against previously incurred capital expenditures) and non-transferable interest payment of debt costs. To determine the annual adjusted owner benefit, one must add-back any personal expenses of the owner that flows through the financial statement, the owner’s salary, and non-recurring costs that the buyer will not incur.
Maintenance Capital Expenditure Needs of Manufacturers
Manufacturers generally require a large amount of capital expenditures or equipment with a useful life of more than 12 months. Often, equipment must be upgraded and replaced in order to properly maintain the company’s operations. The ‘maintenance cap-ex’ of a manufacturer refers to a long-term asset (with a useful life of more than 12 months) needed to sustain the current level of sales and profits. Capital expenditures (including maintenance cap-ex) do not flow through the profit and loss statement as it is capitalized as an asset on the balance sheet. The depreciation charges from capital expenditures (taken over a number of years) do flow through the profit and loss statement. As we have seen, EBITDA excludes depreciation charges. In the case of manufacturers with an ongoing need for new and upgraded equipment, however, it is generally wise to deduct depreciation from ‘maintenance cap-ex’ in order to calculate the adjusted owner benefit.
Example of Valuing Manufacturer
- Let us suppose that Barry owns a pasta manufacturing company and consults a professional business broker to assess its current value.
- Barry informs the broker that only his specialized and unique equipment (along with a small but highly trained team of laborers) can make the different varieties of pasta desired by its local wholesale customers.
- The business broker review’s Barry’s most recent financial statement (using a cash-based method of accounting) and discovers that the annual gross sales are $5M and the annual adjusted owner benefit is $500K.
- The financial statement has a $200K depreciation charge which the business broker properly excluded from the adjusted owner benefit.
- In talking to Barry and reviewing previous financial statements and balance sheets, however, the business broker discovers that about half of the capital expenditures (or $100K of the depreciation charge) is for ‘maintenance cap-ex’.
- Maintenance cap-ex represents money spent on long-term assets which upgrade and replace equipment in order to maintain the current sales and profits level.
- Although maintenance cap-ex is not an expense in the financial statement, its depreciation should be deducted from the adjusted owner benefit.
- This results in an adjusted owner benefit for Barry of $400K ($500K – $100K).
- Barry has an established business of over twenty years, a strong gross margin of 40%, little problems collecting from its customers, and a strong growth trajectory.
- As such, the business broker assigns the company a valuation of $1.6M, or 4 x its adjusted owner benefit.
- The account receivables may be retained by Barry and the inventory sold separately at cost.
The owners of manufacturing companies should identify their competitive advantage (if possible) prior to its sale. This will go a long way toward justifying their asking price. Valuing a manufacturing business should always be done within the context of realizing its need for working capital and the amount of capital equipment necessary to sustain its business.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.