That's the Bottom Line

That's the Bottom Line

• Posted By Andrew Morgan

Any business survives (or thrives) when it produces a strong profit.  Whether it’s a sole trading hairdresser or a listed public company such as one of the Big Four banks.  The fundamentals are the same, produce a strong profit and those profits ensure the survival of that business and are then spent within the community at other businesses whether they be petrol stations or supermarkets, etc.  The publicly listed company will distribute profits as a dividend to investors who will spend those funds at businesses within their community as well.

There are always different ideas, beliefs and information that people work from and in this case we are referring to the importance placed on Revenue and Profits.  Each has an important role to play within the success of any business, but which is more important than the other?  Different schools of thought will say things like, “concentrate on the top line and the bottom line will take care of itself”.  Others will say, “it’s not what you take, it’s what you make”.  At the end of the day, both are correct (with certain caveats attached), but the bottom line or Net Profit of the business takes over when all is said and done. 

When a potential investor is considering buying a motel business, the first piece of information they want to know after the asking price, is the Net Profit.  Further to this, all the other information about this business has a diminished degree of interest.  Comments are often made in regard to the Revenue of a business not being high enough.  This seems like a strange query particularly when one has the revenue, expenditure and profitability is laid bare.  Unless one is planning on operating the business less efficiently, at a lower profit margin or higher cost base, why is the revenue not high enough?  Usually, a new owner or operator of a business will be focusing on reducing overheads and improving profit margins, to increase the Net Profit and therefore the value of the business.  The value of any business is largely determined by two factors, the return on investment (capitalisation rate or yield) and of course, the Net Profit result of the business against this yield.

A business producing a high profit margin will generally have low overheads and therefore a high profit percentage in relation to Revenue.  Vice versa for a low profit margin, with high operating costs incurred to produce Revenue.  Every business will produce a different profit margin.  Two similar motels for example will have so many different variables that will affect what profit margin it achieves.  The Net Operating Profit of any type of business is the determining factor for assessing the business’ value.  No valuer determines a business’ valuation on what Revenue is produced.

The value of cashflow to a business, relates directly to the day to day operation of the business, not the on-going Net Operating Profit over the period of say a year.  It stands to reason though that any business with a higher Sales Revenue that also has higher Operating Expenses, may therefore have the same cashflow problems that a motel with lower sales and lower expenses has.

A simple table can help explain.

With both these motels being valued at the same value in the market due to their returns on investment being the same, why would a lower Revenue make Motel B worth less than Motel A?  These motels have very different Revenues, however their Net Operating Profit is the same.  The reasons for this can be numerous, however a few explanations may be that one is operated more efficiently than the other, or because one has a source of Revenue that is not as profitable as others, or because the particular location attracts higher operating costs, etc.  A big one is often the underselling of a unit.  A 90% occupancy rate on a tariff 20% less than what is achievable will do it!  In other words, discounting!  The easiest way to create a higher cost base and operate less efficiently.

Either way, the business with the lower Sales Revenue is not worth any less than the one with the higher Revenue?  I would assume that the business with the lower Revenue and Higher Profitability could end up being more attractive in the market than the Motel with the higher Revenue.  This could be due to it being potentially less labour intensive or having a lower level of risk than the other, by being able to operate at a lower cost base.  Without foundation, one may argue that Motel B with a lower Revenue than Motel A carries a higher risk level.  Only if the next owner plans to operate it less efficiently.

As mentioned, a Registered Valuer who is doing a Valuation on a Motel Property or Business will base their valuation on a Capitalisation Rate of the Net Operating Profit of the business, not the Revenue.  Therefore in the above example, with all else being equal, Motel A and Motel B will be valued at approximately the same level, even though they have substantially different Revenues.