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Basics on the financials for metal fabricators

A working guide for nonfinancial manufacturing professionals

In January I introduced the notion of company valuation. The measures used to derive valuation are compatible with the overall measures that companies use for their regular improvement initiatives. Financial and improvement metrics are generally the same or very similar, though the emphasis may vary depending on the company’s current strategic thrust. For example, a company may decide to maximize profitability for a period of time at the expense of sales growth. Conversely, it may decide to maximize growth knowing that, at least for a while, profitability as a percentage of sales may suffer.

Both profitability and growth are measured for improvement efforts. And as it turns out, both are also important parameters in valuation.

Valuation Factors

Generally, five categories are examined to determine company valuation. The first, and simplest, is size measured by annual sales, as discussed last month. The others are:

  • The financials: current, historical, and projected.
  • The market characteristics: the total size (in dollars) within the company’s reach; number of prospective customers for the company’s offerings; how deeply and profitably the company has penetrated that market; the market’s growth outlook; and the threats that exist—everything from competitors to technological change.
  • The company’s value propositions and fulfillment means: what differentiates the company, why customers choose the company over others, and the company’s ability to fulfill value propositions. The last is a measure of the company’s operational effectiveness. Included in this category is the quality of the company’s human capital.
  • Regulatory, legal, governmental, and certification issues: OSHA or EPA matters; lawsuits against the company; and whether a company has certifications, like ISO 900x, desirable to some buyers or prospective customers.

All are important in assessing risk-adjusted valuation, but the one that gets the most immediate attention, rightfully, is the financials—the numbers, as the pros call them. The numbers summarize how well the business is doing and its overall financial health. They are the numerical results of how well we have developed viable value propositions, how well we have sold them, how much the marketplace actually values them, and how efficiently we fulfill them (meaning how efficiently we make what the customer wants).

The first number is the top line: net sales (shipments, not bookings) or, alternatively, revenue. As discussed last month, this number has an outsized effect on valuation, mainly because of perceived risk and transaction cost. Large companies are viewed (accurately or not) as inherently less risky than small ones. However, this number is hardly the end of the story. It is usually only the beginning. The numbers that follow are extremely important, because they tell what we did with that revenue.

Measuring Margins

One number that follows is gross margin. This is a combined measure of how well our value propositions and differentiation are actually valued in the marketplace, and how efficiently we make and deliver the products that the customer bought. It’s a combination of prices we can realize and costs to build the products. Technically, it’s defined as the difference between the value of products shipped (sales) and the costs to make the products. Included are the direct costs (direct labor costs incurred in the actual production plus the cost of the materials used) and the indirect costs (depreciation, scheduling, operations management/supervision, purchasing, shipping/receiving, production engineering, supplies, maintenance, facilities, etc.).

Of importance is how gross margin stacks up against the industry average and key competitors. The attractiveness of a given gross margin as a percent of revenue varies widely by industry. If you are in the semiconductor or software industries, a 60 percent gross margin would be considered OK but not great. In custom metal fabrication, a 35 percent gross margin would put you in the upper echelons of the industry. Gross margins lower than the industry average are not viewed favorably in company valuations but, as we shall see, are not fatal either.

When we work on operational improvements of any kind, we often (but not always) work on improving gross margin. Of course, raising prices improves gross margin also, but for most companies that is problematic.

There are two problems in comparing companies by gross margin. First, companies don’t necessarily measure it the same way. Some do not include facilities payments in their manufacturing costs; others do not count interest on money borrowed for machines and equipment. Second, gross margin is sensitive to volume. The higher the volume, the more the indirect costs are distributed, reducing the unit costs of production.

This is why actual valuations often include less inclusive, but less ambiguous, measures such as direct margin (sales less direct labor and material) or variable margin (sales less direct labor and material and other production costs that vary directly with volume). Both direct and variable margins are much less volume-dependent, which is why I always include them in an analysis for purposes of valuation and improvement.

Profit Before Taxes

The second important measure is pretax profits, or PTP (in many cases, this is the same as operating income). PTP is what’s left of our gross margin after we pay general, sales, and administrative (GSA) expenses. These are expenses for accounting, selling, product development engineering, general management (and sometimes operations management), and facilities and depreciation not charged to production. These also include expenses for some or all interest, some or all insurance, and human resources administration.

These expenses are not related to production. They are therefore viewed as “fixed” or, more precisely, “period” expenses. Like indirect production costs, they do not vary much, if at all, with changes in volume within a range.

PTP is usually volume-sensitive. The reason it is sometimes wise to lower prices to gain higher volume is that the indirect and GSA expenses are spread over more units, lowering their costs and raising PTP. (Caution: A lot of care and thinking must be employed before using this gambit; it’s called incremental pricing.)

PTP has a related measure called EBITDA (pronounced EE-BIT-DAH by the cognoscenti). It stands for earnings before interest, taxes, depreciation, and amortization. Put another way, EBITDA is PTP with charges for interest expenses as well as depreciation and amortization added back. EBITDA is often (and roughly) equated with cash flow. It gives a measure of how much cash the company is generating (a good measure in its own right) and, therefore, how much debt a company can incur safely as well as how much cash is available for investment or dividends.

EBITDA has become a very common metric when people talk valuations. Deals are often described by the multiple of EBITDA asked for or paid. It is an important shorthand way of talking valuation and is part of almost any internal valuation method.

EBITDA is completely related to PTP, gross margin, and depreciation. If investing in a new machine increases gross margins and PTP, EBITDA will rise also. The actual multiple of EBITDA realizable in valuation is a function of company size, gross margin, PTP, and the state of the other categories—including return on net assets, or RONA.

Produce More With Less

Return on net assets is often the acid-test number for smart companies because it incorporates PTP and asset management into one metric. It is defined, on a pretax basis, as PTP multiplied by net asset turns where net assets are total gross assets less depreciation. Asset turns are simply sales divided by net assets.

Machinery and equipment, inventory, and accounts receivable are usually the major components of net assets. Obviously, the more a company can produce with the least inventory, machinery, and equipment, the better.

RONA is, in my opinion, the most important number. It’s why lean manufacturing is so powerful. It addresses not just profitability, but also the assets required. Notice that you can have a low PTP (common in this industry) but have a great RONA if you spin your assets fast enough. Believe this: Buyers are buying because of RONA potential.

About the Author

Dick Kallage

Dick Kallage was a management consultant to the metal fabricating industry. Kallage was the author of The FABRICATOR's "Improvement Insights" column from May 2012 to March 2016.