Last October I published a blog post titled, “The numerator or the denominator: Which drives value in a family business?” Since then, I’ve received several inquiries about what a company can do specifically to improve its value. Today I will discuss the denominator side of the equation: managing risk in a family business.
There are various facets to evaluate when reviewing business risk. I put these risks into four categories: financial strength, competition, management, and earnings stability.
Having a financially healthy family business is a great start to increasing the value of your company. A financially healthy company has the ability to sustain the ups and downs of the business cycle. It also has the capacity to take advantage of market opportunities. Metrics around liquidity (e.g., the current ratio) and leverage (e.g. debt to equity ratio) are common measurements that can be used to track your company’s financial strength.
Being aware of your competition is another key factor in managing risk in your family business. Understanding how to differentiate yourself through your products or services is highly important. Perform a competitive analysis at least annually to understand where you compete and how you compare to other companies in your industry. This exercise provides important insight to determine where you should focus your efforts to improve your business.
Management Ability and Depth
Just like in sports, it’s important for a family business to have the best leadership team. A strong management team reduces risk. It’s no surprise that companies with more effective management teams usually run more smoothly. You can evaluate your management team’s effectiveness by monitoring turnover ratios for key assets like accounts receivable and inventory.
Retaining your key executives is critical. It’s a good idea to review incentive plans periodically to ensure they are still competitive. Also, make sure your executives have a signed covenant not to compete. A great way to do this is to incorporate non-compete language into your standard employment agreement so it is addressed when an executive joins the company.
Profitability and Stability of Earnings
Lastly, the longer your company is in business and experiences steady profit growth, the better. Increasing profits over a long period of time is a competitive advantage that dramatically increases the value of your business. Two key metrics to monitor in this area are annual revenue growth and operating profits. Return on assets is another key metric that can provide insight into how effectively your family business manages profitability.
As you can see, there are certainly many ways to limit business risk and influence your company’s overall value. In my next blog post, I will discuss ways to improve the numerator!