What cash flow, profits and valuation mean to a contractor

This week, we’re breaking down three essential components of your company’s long-term health: cash flow, profits, and valuation.How can you maximize all three, and how do they affect each other? Tune in to find out.

Topics we cover in this episode include:

  • How your cash flow can get wrecked when you’re growing
  • Seven cash flow drivers
  • Be careful with your line of credit 
  • How cash flow, profits and valuation affect each other
  • How to get clear on your cash flow situation
  • Balancing growth and borrowing

Find all episodes and related links at ContractorSuccessForum.com.

Join the conversation on our LinkedIn page: https://www.linkedin.com/company/contractor-success-forum

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Rob Williams, Profit Strategist | IronGateESS.com
Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | McWins.com

TRANSCRIPT

[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today, we’re discussing what cash flow, profits, and valuation mean to a contractor. Because here on the Contractor Success Forum, we discuss how to run a more profitable, successful construction business. And we’re gonna talk about what that means today.

And who is here to talk about that with us today? We have Wade Carpenter, Carpenter and Company CPAs. And we have Stephen Brown, McDaniel-Whitley bonding and insurance agency. And Rob Williams is me, with IronGate Entrepreneurial Support Systems. 

So guys, what does that mean to us? When we talk about what cashflow, profit, and valuation means to us as contractors, what comes to mind with you guys?

[00:00:57] Wade Carpenter: For me, always is like, hey, how can we maximize all three of them?

[00:01:01] Rob Williams: Yeah. See, and that is what we think and why don’t we just maximize all three of them, why don’t we just go make as much profit as we can and just keep selling? Have you ever seen that be a problem, Stephen, for somebody on the bonding?

[00:01:16] Stephen Brown: I don’t know, it, you know, I guess it’ll kill you at some point. And then you can’t continue to produce profits if you’re dead.

How your cash flow can get wrecked when you’re growing

[00:01:22] Rob Williams: Well, part of my point is there’s this tool that I’ve been using called Cash Flow Story, and go back a long way, Wade actually was using it before me, but talking about the cash flow drivers and how cash is the life blood of your business. So if you don’t have any cash, you can’t continue to make profits because you’re not gonna have any blood. Your business is gonna be gone.

So there was a great example of a $40 million plumber. It’s actually a real story. And he was going, doing great, and he thought he was just killing it. He was killing it, but not in a positive way. Because he had over 2 million worth of profit and it was growing and growing. And the banks came and had a meeting with him and were gonna stop his lines of credit and he had $12 million of loans out there for this 40 million business. And it was crazy. So he was within a year of going bankrupt, even though he was growing like crazy and having more and more profits. And he was just looking at his income statement. He was not looking at his cash flow, and he wasn’t looking at his balance sheet and he wasn’t looking at the valuation.

Most people don’t even have a tool where they’re looking at the valuation. So he’s thinking, gosh, this business is going up. So, again, cash flow and profits are two things that we’re talking about. Wade, that’s just like a common theme that we’re addressing over and over again.

Profit. But where’s the cash flow? What, how can that kill you?

[00:02:57] Wade Carpenter: Well, that’s what we talk about a lot, the fact that, once we’re growing, especially the faster growth, the more capital it takes to support that. And it either needs to come from your pocket or outside forces because if you double your revenue, you tend to double your receivables, which means that’s more money that you’ve got tied up in the receivables and it’s not in your pocket. So the story you’re talking about is an easy way to grow yourself right out of business.

[00:03:25] Rob Williams: Right. And it was interesting. This example, well, I say it was fairly extreme, but it’s fairly common because he increased his debt by $3 million where he made a $2 million profit, but then he’s gotta pay taxes out of that. So he could put all of his profits back into the company and it wasn’t even 50% hanging onto his cash flow.

Being able to pay for that growth. We always say, let’s just put that money back in. Let’s put it back in. And we preach, you need to take some out for yourself all the time. Take your profits first. But the problem is you can’t sustain it because of something we call the cash flow cycle. And that’s, how long is your money being tied up in there? You go back in the very beginning from the time it takes you to make those sales, that costs you money. Getting the sales. And then you have your product and you’re building the product and we might call it Work In Progress for us. And then you invoice it and then you’ve got all that time to get that receivable. And now you do have some time on your payable. You may have seven days or 30 days to pay your materials or subs based on what it is, but you might be receiving that money in say 60 days.

So a cash flow cycle, that might be 120 days. So all the way from beginning of sales and then minus what you’re able to keep some of your payables, but you may have a 90 day, 120 day. I just ran one with a new client the other day, and we had 120 day cash flow cycle on there.

[00:05:00] Stephen Brown: So, so once you realize that, what do you do to help?

Seven cash flow drivers

[00:05:05] Rob Williams: Oh, that’s a great question. Isn’t it? I am looking at Wade. You can’t tell where I’m looking. This is a podcast. But we go to those cash flow drivers and in the cash flow story, which this is a whirlwind of information in a very short time. So we can do a lot of follow up episodes, but you have your, we say seven cash flow drivers. 

You can increase your prices or your profit margin. You can increase your volume of your business, which could be positive or negative on your cash. You have your cost of goods reduction, reduce your costs, you have your overhead reduction. Then you can reduce your days of, to your debtors. You know, you’ve got your debtors and then your creditors, your accounts payables and accounts receivables. And then you actually have the money that you’re taking in and out of the company. And I’ve seen some cash flow drivers stated a couple of different ways as I was reading this. Sometimes those are not the exact seven.

But we have a drill and it’s really interesting. We’re just working with a local, it’s a Contractor. He’s more of in the labor business. And we’re putting up in a break room in a room where we’ve got all these cash flow drivers on post-it notes, sticking up on the wall, and then we have the ideas of what you can come up.

What are the ideas that everybody in the team can understand and get your team to understand these cash flow drivers? They’re not gonna understand them. You’re gonna have to communicate that. And then what are ways that you can have ideas coming from your team and you focus on these each quarter, each month, whatever your meeting time period is. And you find ways to reduce or increase these to make them better and better.

It’s not one big thing. It’s a whole bunch of things that you can do along the road. Is that too much to absorb?

[00:06:55] Stephen Brown: No. I think I have the big picture of what you’re talking about. You’re saying cash flow affects, of course, your profit and also the value of your business.

[00:07:05] Rob Williams: Yeah. The value of your business comes down to it also. So in that balance between cashflow and profits, you’ve gotta have your cash flow. Cause cash is king. That’s what we’re in business for. We’re not in business for a piece of paper. We’re in business to get money out of the company to live on and do what we want to with it personally, or for our families.

And it takes cash to pay the people in the company. And that was actually part of our discussion the other day. But one of the other things that this particular owner didn’t realize, he thought he was building the value of the company in terms of, you know, your earnings before interest and taxes and you usually have a multiplier.

And when we took those earnings, And that IBITDA, it was a couple million, you’d think a business would be worth a lot of money because they’re making, let’s just say they’re making 2 million a year and maybe the multiplier is four to five. Let’s even say it’s five. That business should be worth $10 million.

But when somebody buys that business, They’re not buying the debt that goes with it. You gotta pay that debt. So in this case, he had 12 million worth of debt in his loans and his capital payments, those type things in his business. So his business on paper was actually worth negative 2 million.

If it was worth that $10 million, he had $12 million worth of debt. Even though his revenue was 40 million a year. He had no idea that his company actually had no marketable value to sell that company after he paid the debt. He was in shock. He was sitting on top of the world making $2 million a year on paper.

[00:08:48] Stephen Brown: I’m in shock for this guy. I hate this story.

[00:08:51] Rob Williams: I know, it was such a healthy business from the thing. And you dig down in there and you see the underlying part of that. So that’s why we’re talking about what our cash flow, profits and valuation mean for a contractor? You’ve really got to know what all three of those are. You can’t just look at your P and L you’ve–

[00:09:13] Stephen Brown: Well that you–

[00:09:15] Rob Williams: You have those other ones.

[00:09:16] Stephen Brown: That’s a good point. I was looking at a contractor’s financial statement and there was no working capital. So, that means that they were in a cash crisis. They were way overbilled. And looking at the job schedules, they had a number of jobs that had huge profit fades on them and were losing money.

So there was upcoming trouble. So it was like a triple whammy as far as the health of the financials of that construction company. And so the first thing you do when you look at a situation, the three of us do when a customer comes to us and need some help with that is saying, first thing we got to do is fix this cashflow problem and get rid of this debt. And the rest of the things turn around.

Then we’ve gotta do some really, maybe spend a little money to get some accurate accounting data, to figure out exactly where we are and what kind of loss we’re gonna have. Then you take that information to that same bank that was cutting off their line of credit. And you might have some folks that wanna work with you again.

[00:10:23] Rob Williams: You know, one of the bank’s comments was very interesting. The bank said they weren’t really worried as much about the situation with the debt and stuff, because it was still a very fixable situation. They were much more concerned that the business owner did not know that he had this situation. That was– 

[00:10:46] Stephen Brown: Yeah.

[00:10:47] Rob Williams: Big problem.

[00:10:47] Stephen Brown: That’s my point. You get a financial statement that bad, and it just tells you that the contractor doesn’t know, they don’t know. And that’s scary.

[00:10:57] Rob Williams: Yeah. See in this one, I don’t know that I’d describe it as that bad. It was that unusual. It didn’t have to be bad if you knew what was happening. You have a plan for the future cashflow for that. But when it’s just going more and more, and they see that it was upside down, because their fixes to it were not that difficult. Just slow your growth, let it catch up. Do some other things, don’t buy so many– just quit trying to grow so fast. It was not a hard fix. The bank’s problem was that he just wasn’t aware. And he was irate that the bank was mad with him. He’s gonna go to another bank.

So Wade, I just feel like this is actually, I’m sitting here talking about it, but I feel like you’re the expert at this stuff, man. You’re–

Be careful with your line of credit 

[00:11:42] Wade Carpenter: well, I think in the story you’re talking about as well as I see it all the time too, and you don’t see it as much as after the great recession from 10 years ago, but you know, when a company has too much line of credit, it’s easy to fall into that trap of, hey we’re financing our growth off the line of credit.

Even, I mean, sometimes we would take a line of credit and go buy a truck or something. That’s not what a line of credit’s supposed to be for. But when you’re growing like crazy and you’re looking for that capital, well, all he saw was, hey, I’m making this work because I’m able to borrow. You cut off that ability to borrow, and the house of cards comes tumbling down pretty quick..

[00:12:24] Stephen Brown: That’s a great point, Wade. I mean a great point. And when that house of cards starts tumbling down, that’s where we see in the bonding business customers going down and without the desire or knowledge to react quickly it’s just a cycle that just spins itself into bond claims. And there, we’ve got a friend and client that has gone out of business. We’ve lost a good customer and not to mention everything related to that construction company, the employees, and everyone else that depends on them. It’s a sad, tragic story. So, I guess that’s what our Contractor Success Forum is all about.

The three of us are passionate about that, listeners. We care about it. Cash flow, profit, and the valuation of your business. Those are the three elements that you have to think about all the time. If you think about the valuation of your business, whether you sell it or not, then you’re running your company the right way.

If you’re watching those cash flow engine drivers. And you’re making sure that your cash is flowing properly to meet your needs, and you’re not having to go into a lot of debt to finance those needs, then your profits go up. So. I don’t know, Rob, is it like a pyramid or are they, or is it like three circles all tied together?

How do you, how would you describe these important three elements?

[00:13:45] Rob Williams: That’s a great question, because I know a lot of times we do those three circles. When we do that to find a spot. In here, I think of it as a circle more though. Watching the cash flow. And have those profits. And then, I mean, it does lead up to that.

I, you’re kinda catching me off guard here cause I haven’t thought about it yet, but–

[00:14:05] Stephen Brown: Well, maybe three corners of a pyramid, you know, I don’t know.

[00:14:09] Rob Williams: But they definitely build on each other and they affect each other. They all affect each other. 

How cash flow, profits and valuation affect each other

[00:14:13] Wade Carpenter: I mean, I guess when we were thinking about like the cash flow story that Rob was talking about or anybody that gets in that situation, I think you’re talking about, and I brought this up before, but there’s a concept in finance called the fundable growth rate model. And that’s basically saying if you’re growing so much, how fast you turn profit to be able to grow that?

And if it’s not coming from your operations, it’s gotta come from either your own pocket or somebody else’s pocket. Injecting capital or borrowing the money. And that’s where people should probably stop and take a look at, hey, we’re growing, where did the money come from to fund that growth?

And sometimes you have to wait until that fundable growth rate comes up to, like what Rob was saying, gotta slow down. Otherwise you can’t really do that. So you can’t grow as fast as you would like to.

[00:15:12] Rob Williams: So what do we do? How do people get a value out of this today? Because this is a big, broad topic. So what do you do with it? If you’re listening to this today?

How to get clear on your cash flow situation

[00:15:21] Rob Williams: Do you know what your cashflow was?

Hardly anybody can ask that. They can answer what their profit was, but what was your cash flow? How much loan did you have to get and do you even know what that means? And are you looking at a cash flow statement? Rarely, when I talk to a new person, do they have a cash flow statement in their reports that they get.

It’s probably in their software, but do they get that? Are you looking at it? How much more money did you have in the bank? How much did your bank loans change? How much did you take out of the company? That’s cash flow at, you know, what’s a different adding all those up together. That’s your cash flow.

Or was it negative? Did you have to put money in there and you’re growing. Just know that. Be aware. If you’re not aware of that, ask your CPA, your bookkeeper, your CFO. Reach out to somebody, I know Wade and I are here and Stephen can help probably too. And we’re here.

It’s really not that hard to do that. Reach out to somebody that has that information. We do it frequently it’s something that I really like to do. I think that’s a great way to start a conversation with somebody.

Find somebody who’s your trusted advisor, make sure you understand your cash. And having that valuation. I’m making the assumption whether you’re profitable or not. Maybe I shouldn’t make that assumption, but that’s the assumption I’m making, so know what your cashflow is.

Was it positive? Was it negative? And how is your valuation being affected through all these things? What is that? That’s something I think you should look at quarterly or at least annually, and really be aware of that. If you’re not, tell your advisors, whoever you’re dealing with that you’d like to look at it. Give Wade a call, give me a call, give Stephen a call and–

[00:17:07] Stephen Brown: And I’ll refer Rob and– 

[00:17:09] Wade Carpenter: To kind of summarize some of the stuff you’re saying, I mean, I think about it from the valuation standpoint. You’ve got your profitability and you’ve got cash flow and they’re literally, when you’re doing a valuation of a company, there are seven or eight traditional methods of valuing a company.

And sometimes we use hybrid methods. But two of them are based on a multiple of cash flow or profitability. We’re talking about your profitability or your cash flow can affect the ultimate valuation of your company. 

But as far as the valuation or the cash flow, they’re all intertwined. And so you have to take a look at it and maybe we shouldn’t always be looking at, hey, just this one metric, the profitability or just the cash flow, but maybe return on equity return on assets will tell you a little bit better of, are we winning the game as opposed to, are we borrowing from other people to build our nest egg. And borrowing to leverage your growth, if you do it smartly, is not a bad thing. But there is a point where it’s too much. That’s just my take on it.

Balancing growth and borrowing

[00:18:19] Rob Williams: I’m glad you said that. There’s a balance in between there at your growth and the thing there’s the Guy Kawasaki method that says, never use your own money. Always use somebody else’s money. 

Then there’s the Dave Ramsey over there. You know, no debt, snowball. Don’t have anything. So where are you gonna be in between those two somewhere? On one end or the other? From no debt, no debt to never use your own money and do everything off of debt. So there’s a balancing in there. And Wade, what he just said is a good way to think about that.

Because there are multiple factors in there that you have to think about. And the valuation and some of the companies that I’ve talked to they have a good point, their value of exit plan is not really a multiplier of IBITDA. They own things in their company that are worth more than the multiple of their profit, so they’ve been purchased for different reasons.

I had a business partner, he was purchased because of the value of his software. When Illinois Toolworks bought it from him, he had a small audience. So it was worth 20 times more to Illinois Toolworks because they had such a huge customer base. So his profitability in his company didn’t matter, which is a good thing because he, his books were not good.

I have another company that I’ve talked to, their valuation is more a revenue thing because they make a drink product. And it’s just based on their sales, that company is gonna buy it or is gonna buy their brand. They’re not gonna buy their company. 

So there are things and there’s some examples of your systems and processes that may be really valuable to a big company. So when you hear these really big multiples, that’s probably something else going on there. Don’t think you’re gonna get that 10 times or 20 times because they’re not buying that revenue.

And what does that company worth to you on evaluation? Because I’d say, Wade, a whole lot of people choose to keep their company once they see the valuation and they can do it. If they’ve got that, they’re like, well, why would I sell this? Because this is a lot better return than I would get on the money with my thing, and I feel really stable. And I know this. I may not wanna work in the business anymore. I may turn this over, but I’m gonna keep my ownership– all or part of those ownership rights. And I’m gonna keep this thing, so that valuation can be a self valuation as well.

So anyway, there’s so much that goes into it. And thanks for pointing out, Wade. There are multiple ways to value the company, but it is really good to keep a benchmark on that and keep your finger on that pulse.

[00:20:54] Wade Carpenter: Since you just brought up something else and I know we don’t have time to go into it today, but you know, you talk about getting that 10 times multiple and you shouldn’t expect that. Well, if you understand what drives the value and what drives the multiplier.

[00:21:07] Rob Williams: Yeah.

[00:21:08] Wade Carpenter: Just, classic example of, Michael Gerber and The E-myth. If you build the systems where they can reproduce that, you know what you’ve been doing, your profitability, your cash flow, then you can bump those multipliers up. So I know that’s a topic for another day. 

And just going back to the debt thing, I refer to it as smart. A lot of times people are in survival mode when they first start off. But too often too many contractors stay in that survival mode their entire life. But once you can get past that, or if you make smart moves and smart use of things like lines of credit and get past that, you can, I mean, we’d all love to be where Dave Ramsey is, like everybody out of debt. If you’re using the debt to get to another level, that’s a different topic. So, a lot of times people have to get to that point where they can move forward. So hope that makes sense.

[00:22:01] Rob Williams: It does. Smart debt and smart growth, I think they’re they’re in line with each other. I really like this show. I don’t know if it’s broad, but I really like this as an overall view of what we are trying to provide here at the Contractor Success Forum.

And to me, this is sort of what the basis is about, of the business side of these things. So appreciate this episode. Thanks, Stephen. As a bonding thing is this meaningful to you guys?

[00:22:31] Stephen Brown: Absolutely. Poor cash flow, no profits. And then no net worth in your company. not good.

[00:22:39] Rob Williams: All right. Well, thanks a lot. This has been a great episode of the Contractor Success Forum with Wade Carpenter, Carpenter and Company CPAs, Stephen Brown, McDaniel Whitley bonding insurance agency, and Rob Williams with IronGate Entrepreneurial Support Systems. Let us know if you have any questions and give us feedback. We’d love to hear from you guys.

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