In the champagne flute days of 2005, the owner of a $100 million pro dealer boasted to peers that his business earned only a 2% EBITDA (earnings before interest, taxes, depreciation, and amortization). He was well aware that a typical pro dealer’s EBITDA averages 4% to 5% and that, at the market’s peak, top performers were reaching 10%. But even in good times, this owner targeted 2%. Why? He replied that “$2 million in annual earnings is a lot of money, and I don’t need more than that.”
Back then, this owner’s response struck me as a refreshing rejection of unrestrained greed. Here was an entrepreneur who built his business from nothing into one of the nation’s largest pro dealers. He had reached his personal financial goals and saw no need (including ego) to drive profits higher. You might feel the same.
But today, six years into a housing crash, that dealer is struggling, and were it not for low debt levels and the owner’s willingness to cover operating losses, it might have gone out of business.
That story leads to this lesson: From a pragmatic standpoint, relentless maximization of a business’ profitability, within legal and one’s moral bounds, must be a top priority.
To do otherwise puts your business in long-term jeopardy, for several reasons.
We know that cash flow is a company’s lifeblood and profits are the key long-term driver of cash flow.
In a cyclical industry, bad times always lie ahead. Cyclical downturns’ timing and duration are unpredictable. When they arrive, competition will intensify the downturn’s effects and most pro dealers will face periods of unprofitability.
Every dollar of profit that could have been earned but wasn’t is a dollar that fails to get stockpiled into a war chest of cash for bad times ahead. The bigger a business’ cash war chest, the greater that business’ margin of safety to survive extended downturns.
Likewise, tolerating unnecessary expenses in good times puts a business that much further from break-even profitability in bad times. The higher one’s overhead, the more difficult and painful right-sizing will be to get to break-even status in bad times.
Unnecessary expenses hurt a business’ competitiveness versus existing and future competitors. In a dynamic marketplace, there is no such thing as a static competitive position—your business is either improving or not, growing or dying, becoming more or less competitive, each day. Unnecessary expenses make your business less competitive.
Profits are a business’ measure of health, both for management and for stakeholders. The clearest way for you and your creditors, lenders, investors, and related parties to understand whether your business is improving over time is trends in profitability. Profit growth begets profit growth due in part to lower cost of capital and better working capital terms. Businesses that aren’t run to improve and maximize profitability have cloudy metric trends, a symptom of cloudy business health and long-term prospects.
A business is its own entity, legally and in spirit. It has its own unique needs, not always aligned with those of the business owner. While maximizing profits may not be a top priority for a business owner, it must be a top priority for a business. Otherwise the owner puts the business’ health and longevity at risk.
When the interests of the owner diverge from the business, it may be time for the owner to explore alternatives, such as refocusing on the business’ needs, installing professional management, or selling the company.
Matt Ogden is managing principal of Building Industry Partners LLC, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. E-mail: email@example.com. 214.550.0405