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Entrepreneur magazine - January 2001
By David R. Evanson & Art Beroff
URL: http://www.Entrepreneur.com/article/0,4621,284769,00.html

Go Figure!
Ever wonder just what investors are looking for when they pore over all those numbers in your financial statements?

In a period of boundless opportunity, it seems unlikely that a company would attempt to find explosive growth in an established industry. But that’s what Lynnfield, Massachusetts-based Investors Capital Holdings has done.

Since the company started in 1995, Investors Capital has doubled its revenue every year by providing financial services to consumers—a business where even some giants have stumbled. Co-founder, president and CFO Tim Murphy says a key component of Investors Capital’s success (the company had $34 million in annualized revenue in 2000) is a “commitment to good old-fashioned customer service and intensive recruiting.” The result is a sales network of 1,200 representatives, a force even some brand-name competitors might envy.

“We’re ready to turn up the heat with Internet-based financial services, expansion of our mutual fund [offerings] and the opening of more company-owned offices,” says Murphy. But expansion requires capital. To meet the plan’s needs, Investors Capital filed for an $8 million initial public offering.

In making the transition from a private company to a public one, Murphy says, Investors Capital had to open its books to investment bankers considering the offering. What were the bankers looking for? What did they find there that made them commit to the deal?

The answer is in the company’s financial statements. Owner and CEO Ted Charles has always found great benefits in keeping good financials. “[Preparing financials] gives you a great perspective on where the company is—you can see the numbers because you’re auditing things constantly and setting goals,” he says. Now the company’s financials have played a bigger role, conveying the business’ strengths to investors.

One of the tricks to raising money is knowing what investors look for in financial statements. Jim Twaddell, director of corporate finance at the Providence, Rhode Island, office of Schneider Secu-rities, was the investment banker who liked what he found in Investors Capital’s books and agreed to do the deal. “Equity investors and lenders look at finan-cials differently,” he says. “Lenders are seeing if a company can repay a loan. Equity investors are seeing if a company will grow, and what that will take.”

David R. Evanson's newest book about raising capital is called Where to Go When the Bank Says No: Alternatives for Financing Your Business (Bloomberg Press). Call (800) 233-4830 for ordering information. Art Beroff, a principal of Beroff Associates in Howard Beach, New York, helps companies raise capital and go public, and is a member of the National Advisory Committee for the SBA

Twaddell says his first stop in evaluating a company is usually the income statement. Most investors look here to see whether gross, operating and net income margins are in line with industry averages. "If not, it's a negative," says Twaddell. "Then again, it doesn't have to be the kiss of death. Many companies have not reached the critical mass on sales that will reduce the effects of fixed costs, or may be experiencing high costs because they're growing."

What is an income statement, you ask? Read Income Statement to get the facts straightened out.
Such was the case with Investors Capital. For the quarter ending June 30, 2000, the company's operating margin was a trifle thin at 2.8 percent. After all, firms with similar business models were booking as much as 8 percent. "But we incurred a lot of expenses expanding our business," says Murphy, "and we anticipate this investment will drive future earnings." Investors Capital's torrid revenue growth bears this out.

Next, according to Twaddell, most equity investors examine the composition of revenues. "They are looking to see if the revenues have gravitated to the higher-margin business and will probe the degree to which revenues are recurring in nature," he says. "Revenues which occur over and over again without the stimulus and cost of sales promotion are ideal because they increase the company's overall profitability."

On the expense side, Twaddell says, "ideally, there will be operating leverage, which means that as the business grows, expenses as a percentage of revenues will level off or go down." The absence of operating leverage does not mean the business will be unattractive to all investors, but it could be a defining characteristic. Adds Twad-dell, "Some investors shy away from companies that cannot achieve operating leverage."

After the income statement, Twaddell says many equity investors check the cash-flow statement to see what’s really happening in the business. It’s this statement that makes adjustments for all noncash transactions to show just how much cash is used or thrown off by a company. Items such as depreciation—an expense that cuts into earnings but doesn’t eat into cash—are added to cash flow. Accounts receivable, which get booked as revenue but don’t provide real cash, are taken out of the cash-flow calculation.

Need more explaining? Read Cash Flow Analysis to have the fog lifted.
There are myriad inferences investors can draw from cash-flow statements, says Twaddell. But ultimately, they’re looking at the capital intensity of the business: “how many dollars have to go in on the front end before one pops back out on the back end,” he says. Seasonality (which requires companies to spend even when revenue is not being generated), lengthy collection periods and growing accounts receivable require capital. So the question in investors’ minds becomes, How much capital will this business require, and is there a plan in place to fund its growth?

Investors Capital scored well here, says Twaddell. The company’s receivables, mostly commissions from insurance companies, were paid in 30 days or less. There was no cyclicality in the revenue stream to speak of, and cash-flow statements showed the company was almost entirely self-funding. “As a result,” says Twaddell, “the capital raised in the IPO wouldn’t be used to fund operations but expansion and, presumably, increased earnings—raison d’être for most equity investors.”

No company analysis would be complete without looking over the balance sheet. In today’s tech-laden world, equity investors focus on intangible assets—a moot point for Investors Capital because the company hasn’t developed proprietary technologies or processes.

Typically, says Twaddell, investors have comments or questions when it comes to intangible assets. At the broad-brush level, if the company shows a large amount of intangible assets, it’s generally perceived to indicate a significant commitment to creating or maintaining a technical edge. However, the investor may question or challenge the way a company capitalizes research and devel-opment (that is, the degree to which the company treats these expenditures as assets, as opposed to treating them as expenses, which reduces net income). “If a company is too aggressive in its capitalization policies,” says Twaddell, “securities regulators or the company’s own certified public accountants may someday force a reclassification of the expenditures and, in the process, deliver a big hit to earnings.”

Next, many investors look at inventory to see what the growth trend is relative to sales. If it’s crept up over time, and there’s no big sale on the horizon, the investor may feel the company has lost touch with changes in the sales cycle. The investor also looks at the number of days sales are tied up in accounts receivable, which is calculated by dividing receivables by net sales, and dividing that quotient by 365. “If the figure is creeping up over time, it could indicate several things, but the investor may question if management is putting the right amount of effort into collecting cash due the company,” says Twaddell.

Investors Capital’s business precludes inventory, which is a plus in investors’ eyes because inventory eats capital and causes problems when not managed well. Investors Capital also scored well in accounts receivable because receivables are paid in less than 30 days—a far cry from the 90 days companies that have to deal with big chain retailers typically wait.

When they move on to the liabilities side of the balance sheet, investors zero in on the accounts payable section. Specifically, investors want to know how many payables are more than 60 days old. “If it’s a significant amount, it can be a problem,” says Twaddell, “because investors will see a significant portion of the proceeds being eaten up just to keep vendors happy. That can be a real deal-breaker.”

Investors also look for any term loans. In general, says Twaddell, their comfort with the loans varies directly with the term. Therefore, if you have significant liabilities due in one or two years, the investor may recoil. If the term is three to five years, the loans will be less of an issue. Debt-free Investors Capital had the ideal scenario.

Any term loans payable to founders cause problems for entrepreneurs who aren’t flexible. “From the equity inves-tor’s point of view, it’s a losing proposition to pay [founders] off because there’s no growth associated with it,” Twaddell says. “If founders insist on getting paid off, it can kill a deal.”

Next, investors check the equity section of the balance sheet to see whether it’s negative or positive. At the end of each year, the net income or net loss gets posted to the equity section. If a company has lost money year after year, the equity account will be thin. “By looking over the equity section of the balance sheet,” says Twaddell, “investors can get a sense of how close to the edge—or how healthy—a company is.”

Get the ingredients of a balance sheet. Check out Balance Sheet to cook up your own.

"Notes added to financial statements are one of the most important parts of the presentation," says Twaddell. "They tell [investors] things the numbers never can." One more reason to get a CPA-prepared financial statement: In-ternally generated statements rarely have notes, which handicaps investors right from the get-go, inviting them to walk away from the deal until the information becomes available.

Feeling a little out of sync with your money? The Financial Management For Your Business section should get you on track.

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