A few years ago we presented fifty seminars on the subject of agency succession and perpetuation in 26 states. We covered all of the methods of both succession planning and perpetuation planning for several thousand agents in twenty six states and look forward to bringing this message to the agents in all other states because of the timeliness and importance of this subject.
One of the key education points was teaching the agents how we value insurance agencies and how they can do it themselves if they understand their own financial statements and trending analysis. Over the next several months we will cover a variety of topics in the PIPELINE that details and extends the financial analysis that agents can do to determine their (or anyone else’s) valuations.
When less than 10% of the agents in attendance told us that they understand their own Balance Sheet we determined that this imperative analysis and valuation document would be our first topic of conversation.
The importance of the balance sheet and the great differentiation between your Operating Statement (Profit/Loss, Income/Expense) and your Balance Sheet is like the difference between a scale or thermometer on the one hand and the analysis of your blood work or an MRI on the other hand.
Getting on a scale will allow you to find out whether you are gaining or losing weight. If you use a thermometer you will find out your temperature. In the first case, while your weight is important, it is a poor indicator of your general health if used alone. If you feel feverish, the thermometer may confirm or deny that fact, but will not tell you WHY you are feverish.
Similarly, in your business your operating statement may tell you whether you have sufficient income to potentially create a profit for your agency. It may be used to compare you against prior periods to see if you are ahead or behind previous years. Your Operating Statement doesn’t tell you whether you will make a profit this year or even if you have sufficient cash to pay your bills month by month. And because of the quirks of billing and the timing of payments, you can’t even use your operating statement as a cash flow indicator or to accurately determine your financial health by simply comparing one year-to-date to another.
But we have the deeper analysis easily available to properly tell agency owners whether the health of the agency is good or bad, whether the cash flow potential is sufficient to meet the agency’s expense needs, or whether the agency is getting stronger or weaker. Our systems provide us the deep knowledge automatically on a monthly basis and can tell you that at any moment.
The underutilized tool that can define an agency’s health is its Balance Sheet. It will tell us if our agency’s cholesterol is good or bad and whether it is getting better or worse. It will tell you if your business’ heartbeat is strong or weak and whether it is improving or diminishing. And, like your own cholesterol measurements, the health indicators in an agency change slowly over time, not abruptly. And, also like your cholesterol, if you take remedial action to make your agency healthier, the liquidity factors that define your agency’s health will slowly, but surely, improve.
How a Balance Sheet is Constructed:
Your balance sheet is comprised of three sections, Assets, Liabilities and Equity. Your assets are tangible (like cash, receivables and property) and intangible (like goodwill and purchased books of business). Both assets and liabilities are usually split between Current, Tangible and Long Term (or Other). Current Assets and Liabilities are those components that will be liquid in a relatively short period of time (within twelve months). Long Term or Other Assets and Liabilities are those that you will get or that you owe over longer period than the next twelve months.
The universal GAAP (Generally Accepted Accounting Principal) definition you must understand is that your Total Assets must equal (BALANCE) with the combination of your Liabilities and the Owner’s Equity. That’s what makes it a “balance” sheet. Your Equity section of the balance sheet is your inherent value comprised of any stock value, any additional paid-in-capital that you’ve subsequently invested and any Profit (this year) and Retained Earnings (profits upon which taxes have been paid for all prior years that have been left in the agency). If your corporation has re-purchased any stock, that amount forms a negative equity (called Treasury Stock) and diminishes your total equity position.
Once you know the sections of the Balance Sheet and understand the difference between Assets, Liabilities and Owner’s Equity you are ready to calculate the Liquidity Ratios that will define the trended health of your agency as you look at your balance sheets every month.
Agency Liquidity Factors:
The following are the Liquidity Ratios you should measure (and how to measure them) each month. We begin with the two indicators that are most critically important in a sale or purchase of an agency, whether or not the purchase will be internal or external – whether or not it will be a purchase of stock (the corporation) or an asset transaction. Pay attention to these two indicators while you own the agency and you can maximize its value to you and to the next generation of owners when you retire and/or cash in your asset value.
Tangible Net Worth (TNW) is a primary indicator of value in an agency. It is defined as the Owner’s Equity less the agency’s Intangible Assets (like the value of expirations previously purchased and any goodwill) – TNW must be positive and should be more than 15% of revenue. If the Tangible Net Worth of an agency is negative it means that if the agency were dissolved it would have more obligations than assets. It also indicates that, whether a corporation is purchased or an asset sale is conducted, the negative TNW will be of concern. In a change of ownership involving a stock sale, the value of the TNW, positive or negative, either adds or detracts from the agency’s value dollar-for-dollar. In a change of ownership involving an asset purchase in which the corporation and its stock remains in the hands of the prior owner, any negative TNW makes it more likely that the seller will have to have at least the amount of negative TNW as a down payment in order to pay his debts. The seller will want to know the condition of the corporation when deciding on the purchase.
Your balance sheet is not forgiving. In other words, if you use too much of your assets and take all the cash out of the agency every year, it will eventually cause a negative TNW and there WILL be ramifications when you try to transact the agency.
So even if you aren’t buying an agency’s stock, it is important for you to analyze and know the agency’s TNW. On the bright side, if you are conservative and have reserves that create a positive TNW, your value as a corporation will increase dollar-for-dollar by the amount of your TNW over the value of the book of business and, after a sale, you will be left with cash to disburse if you don’t sell the corporation.
Days of Working Capital – Measures the number of days of operating expenses that can be covered by the excess of current assets over current liabilities. If you plan on selling your agency at some point, you should leave 30 days of working capital in the agency that will be used by the buyer to pay the agency’s expenses until it’s revenues catch up in the first month of operation under new ownership. If you take every dollar out of the agency, the buyer will have to sponsor the first 30 days of expenses out of his own pocket and will lower the value of the agency by that amount since it will be a part (an immediate part) of his total obligation in the purchase of the agency.
The method of calculating Working Capital is to take the total annual expenses of the agency less any non-cash operating expenses (like Depreciation and Amortization and Bad Debts) and divide by 365. That determines your agency’s daily WC needs. 30 days of working capital (to cover a month of expenses) is the minimum we expect in a healthy agency. 45 – 90+ days of working capital is standard in a healthy, going concern agency.
The additional good news for conservative agencies with cash surpluses is that in a corporate sale the excess working capital adds value to the agency dollar-for-dollar. If you sell the agency as an asset and keep the corporation you will have excess cash without any debt obligation to disburse as desired.
Acid Test – Cash and receivables/payables. The acid test is a primary liquidity measure used to determine if the firm can meet its current obligations, unless you have a lot of receivables in the ‘Over 90 day’ category and they might not be collectable. This ratio should be over 90% in healthy agencies. If you have a large part of receivables over 90 days (especially over 180 days), a sensible valuer will only look at “collectible” receivables in the calculation of the Acid Test.
Current Ratio – Current Assets/Current Liabilities. This general liquidity ratio measures an agency’s short term (within one year) health. If current assets cannot meet current liabilities (within 12 months), the agency’s liquidity must be strengthened. We look for a 100% Current Ratio in healthy agencies.
Receivables to Payables Ratio – A poor receivables to payables ratio is an indicator of a poor collector. Since there is always a flow of cash coming into the agency, we look for this ratio to be no more than 75%.
Long term Debt/Equity Ratio – Long term liabilities/equity measures long term health and should be less than 150% to avoid cash problems in perpetuation situations in the future.
The value of an agency is established by defining the value of the book of business and goodwill of the agency AND by calculating the agency’s TNW and Working Capital. Agency Consulting Group, Inc. clients and agents who have attended our valuation or succession planning seminars understand how to value books of business. This series is meant to help value and maximize an agency’s Tangible Net Worth and Working Capital reserve.
Tangible Net Worth is defined as Equity less Intangible Assets. It basically defines the liquidity of the agency (its net available funds) and can be used to re-purchase stock from retiring owners or to purchase other assets like other agencies or hard assets for the business. Without available TNW money must be borrowed and causes a liability to the agency that must, eventually, be paid. The basic minimum to keep an agency safe is to have a positive TNW. Agencies that might have to buy out an owner or who may want to invest in other agencies or books of business should have a TNW of 15% of revenue or more. A healthy $1 Million revenue agency should have at least $150,000 of TNW (as defined above) to be considered in prime health. A positive TNW does not prepare the agency for investment in its own future, but provides break-even liquidity (as long as no call on cash is necessary). A negative TNW can be accepted as long as the agency’s monthly cash flow is strong and it is growing. The eventual result of a negative TNW is similar to a family outspending its income for many years. As long as the wage-earners keep making enough to sponsor the debt that it accrues, the process can continue. Similarly, agencies can live with growing negative TNW for years – until something bad happens.
Usually, the loss of one or more major accounts, a reduction or elimination of contingency income or the reduction of commission income due to market downturn or contract changes will capsize the agency boat when in a negative TNW picture. Almost overnight insufficient income will be generated to pay for normal expenses. When an owner leaves or the agency is sold- the house of cards collapses. Money is generated from borrowed funds or from an outside source but there would be capital calls from debtors that would have to be satisfied with the proceeds. This implies the need for higher down payments and, in some cases, the majority of the funds generated in a sale dissolve into the debt owed by the seller after a sale.
We urge the strengthening of Tangible Net Worth through the increase in Equity. Equity increases by the retention of earnings sufficient to more than offset any goodwill and other intangible assets and any Treasury Stock created by any repurchase of agency stock. You need several years to make the equity growth an orderly transition that doesn’t strain agency assets.
If you are preparing to sell your agency, building the TNW to a positive number will give you the best options to maximize your agency’s value. If you are in a growth mode, building your TNW to at least 15% of your revenue base will provide a strong financial basis for growth, whether through the use of agency funds or showing a strong balance sheet for borrowed funds.
You don’t need to calculate an agency’s Working Capital (WC =Current Assets minus Current Liabilities) to know when an agency is in financial stress. If an agency finds it difficult to make payroll, to pay its carriers or to pay operating expenses every month, its WC is insufficient. It doesn’t have sufficient funds in the bank every month to easily cover its normal expenses and the agency scurries to collect its receivables and impatiently awaits is DB commissions to pay its bills.
However the calculation of WC over time will reflect its cash trends and will tell the agency owner whether it is getting financially stronger or weaker. Similarly, if you are considering buying or merging with an agency, a review of its WC calculation over a few years will tell you whether the agency is self-supporting or will need a cash-infusion to continue operating. While increasing revenue is a logical means of strengthening and agency’s WC, a going concern (an agency continuing operation by current owners and participants) can enhance WC best through expense control. And, since most operating expenses are relatively static and unchangeable, the most likely change is in compensation. Unless the agency is overstaffed, the usual culprit in a weak WC agency is over-compensated owners and producers.
While it is easy to cave to producers requests for higher compensation, most agency owners don’t do the basic math of calculating what percentage of revenue is used by non-producer expenses in the agency. If an agency is spending 50% of revenue in operating and administrative expenses and 20% for office compensation and benefits, it could only pay producers and executives an average of up to 30%. At 30% average executive/producer compensation (since most agency owners are also their largest producers) in an example like this, there would be absolutely NO profit potential and the WC would suffer. In many cases, agency income has suffered for any number of reasons and executive compensation remains stable. At some point agency owners must understand that they can take more from the agency (leaving some behind for R&D and growth) as the revenues grow, but the reverse must occur if an agency shrinks.
Learn your own Balance Sheet before you study those of other agencies. Our accountants like to use different terms in the General Ledger lines that comprise Assets, Liabilities and Equity. But the business is YOURS, not theirs. The result of not “owning” your own physical condition when problems strike and just taking the doctor’s word for everything that is happening could be death. Similarly, you must take ownership and understand your own balance sheet to avoid the same kind of “death” if our accountant doesn’t quite understand your business. Insurance agencies are certainly different types of businesses and it is critically important to identifying your real liquidity to be certain that Current Assets are differentiated from Other Assets (Current Assets are those that will be fully liquid within a twelve month period) and Current Liabilities are properly differentiated from Long Term Liabilities (Long Term Liabilities are those that will be due to be paid beyond one year from the date of the balance sheet). Games are played by accountants to make the agency look better for a financer or for a transaction. These are false readings. It would be like telling someone with a 105 degree temperature that his readings are normal. It could make you feel healthier but if you don’t address what cause the high temperature, you will die.
If your balance sheet is wrong (many are), force the accountant to correct it. If your balance sheet is correct and accurately reflective of your health, draw it every month, run your liquidity ratios and trend them.
Balance Sheets are different from Operating (Profit/Loss) Statements. While P&L’s are cumulative during a fiscal year, Balance Sheets are always snapshots of a period of time. That’s why you can run balance sheets backwards for many months and years and develop your historical trend against which you can trend your future liquidity ratios on a monthly basis.
If you need help with this or any part of your financial analysis, please call us 800-779-2430 and we’ll help in any way that we can.