At the end of WWII, the GIs came home to reestablish their lives. Many founded businesses, which grew steadily throughout the 1950s and '60s. A significant number of these businesses grew to what we call the "middle market," which is usually measured by revenue levels between $20 million to $200 million. In the course of building the businesses, the principal founders called on close friends and family as the management talent. The founder and leader personified the tone of operation and strategy pursued at the company. We are now at a stage in the life cycle of these businesses where both legal and financial professionals are being asked to deal with issues arising due to the age of senior management and forces in the marketplace that are placing these companies under increased stress.

The issues faced by middle-market company management exist whether in a distress mode or in a stable condition, whether publicly traded or private. Many of the companies in this category also suffer from the problems of the "lifestyle business," which exists to support the desires of the owners and stakeholders at historic levels. As long as the status quo is maintained, the company peace is maintained. Operating in this manner does not necessarily maximize the value of the business nor allow the operations to be competitive in the marketplace, thus impacting the company's value and continued existence.

As time has moved on, significant numbers of these companies are facing situations where the founder is exiting the business and the next generation of management is taking the helm. As professionals, both the legal sector and financial advisors are dealing with the issues stemming from management in transition and financial crisis.

The situation is an emotional one, where the founding owner is dealing with the "last child" and the extended stakeholders are sensing a significant change in lifestyle looming on the horizon. The process is an emotional one that places the professionals in a difficult position to assist the key decision-makers. Emotions run high as pressure from the stakeholders increases. The role of the professional team becomes one of focusing on the facts in the given situation and assisting the founder in dealing with the decision to sell or restructure the business.

The legal issues will be articulated by the legal team, while the role of the financial advisor will be to provide insight to those factors causing potential financial problems or those that will place road blocks in the way of a possible sale of the business, thereby reducing its value.

The best method for dealing with these issues employs a shift away from confrontational direct approaches and moves to a more clinical, analytical path. This allows a focus on basic financial statement analytical methods and starts a discussion concerning the issues facing the company. An approach not unlike that used by commercial bankers in identifying concerns in the company through analysis of the financials is one of the best ways to focus on the company's issues. This method requires spreading the financials on a comparative basis using programs that can generate comprehensive ratio analysis that provides the basis for discussion with management. Company data analyzed in conjunction with third-party information from sources such as RMA provides the foundation of a focused discussion. The method is tried and true and has been used by analysts for years in assessing companies. Using comparative years on both an absolute and common-size basis for the balance sheet and income statement highlights differences, illustrates changes and begins to draw out issues for further discussion in meetings with management and the stakeholders. The assessment should address a comprehensive-ratio analysis where the subtleties of the problems that need to be discussed will emerge. Comparative analysis provides a basis for a spirited discussion with management.

The discussion with management should focus on those ratios that impact the core of the financial health of the business. Such ratios should be calculated and placed on a comparative basis looking for significant changes in the numbers over time and in comparison to competitors. These ratios indicate wide-range financial activities that can be used to assess the situation and test all facets of the income statement and balance sheet.

The first area to be discussed is the coverage ratio, which indicates the ability of the company to cover interest expense. Coverage ratios are calculated in different ways for different analytic purposes. The fixed-charge coverage ratio allows the analyst to see how well the company covered its fixed charges of interest expense, non-capitalized lease expense, current maturity of long-term debt, preferred dividends and the current portion of capitalized leases. If a company has a fixed-charge coverage of less than one, it cannot meet its fixed obligations through earnings and thus must rely on other funds (e.g., borrowing additional money to meet current maturity of long-term debt or drawing down working capital). The proforma coverage ratio, while having basically the same components as fixed-charge coverage, is forward looking. The proforma coverage ratio attempts to determine whether or not this year's earnings (if repeated) would be able to cover what must be paid in the coming year. The other basic difference is that instead of tax-adjusting current maturity of long-term debt, current maturity of capital leases and preferred dividends at the effective rate (i.e., the tax rate that was actually paid this year), the statutory tax rate is used. The banker's coverage ratio allows "depreciation" to be used as a source and also includes capital expenditures as a fixed charge. A banker's coverage formula of less than 1 is not as worrisome as a less-than-1 result for other coverage formulas, but several years of such performance would indicate that either capital expenditures are excessive in relation to cash flow, or that large amounts of debt are probably being added to fund expansion.

Activity ratios highlight the collection activity of the business. The first considered is the average collection period ratio. This ratio is computed to show the average length of time during the past year that it took to collect a receivable. The resulting ratio should be related to the terms that the company offers its customers. Past days' sales in receivables presents a different and possibly more telling picture of the company's ability to convert sales to cash. Because the average collection period ratio uses the average of two years' worth of receivables at year-end, the resulting ratios may provide a distorted picture. Variations in sales activity near period ends can cause wide fluctuations from one year to the next. In cases such as this, the past-days'-sales-in-receivable ratio gives an indication of how many days' worth of sales are represented in year-end receivables. Average payables turnover is analogous to "average collection period" for receivables. It indicates the average length of time over the year that it took for the company to pay a vendor obligation.

The past days' purchases in payables ratio tells how many days' worth of purchases are represented in year-end payables, while the average inventory turnover ratio gives the number of days, on average, that it took during the last year for the entire amount of inventory to turn over. The past days' cost of goods sold in inventory ratio gives a year-end view of how many days' worth of cost of goods sold are represented in inventory at year-end. The cost-of-goods-sold component of the ratio includes not only the cost of the purchases but also the direct costs associated with processing the raw material to a salable point.

Liquidity ratios provide an indication of the firm's ability to meet its short-term obligations. The liquid or quick ratio is the ratio of liquid assets (e.g., cash, marketable securities, accounts receivable) to total current liabilities. The current ratio is current assets (i.e., liquid assets plus other assets that can be converted to cash within the next 12 months) divided by current liabilities (all liabilities that must be met within the next 12 months). The sales/working capital ratio indicates how many dollars of sales each dollar of working capital is supporting. As sales grow, the amount of permanent working capital needed by the firm should grow at no more than a proportionate rate. The final ratio in this group is the inventory reliance ratio. If all current liabilities had to be met, this ratio infers the degree to which inventory would be needed to fund these current liabilities after all liquid assets were converted. The lower the ratio is, the better off the company is. (A negative ratio is best because it indicates that liquid assets could meet all current liabilities.)

Leverage ratios indicate the degree of leverage that is acceptable. Leverage ratios vary from industry to industry and company to company. However, ceteris paribus, a lower debt ratio is better. Leverage is measured by several key ratios, the first being debt to worth. Debt to worth is total liabilities to total equity and is reflected in several different calculations. The debt to tangible net worth ratio removes intangible assets (e.g., net leasehold improvements or goodwill) from net worth to give a better picture of the assets that could be realized to cover total debt in liquidation. It gives a more accurate picture of a lender's cushion of protection as a creditor. The LTD to capitalization ratio is computed on a firm's capitalization, and it is composed of both long-term debt (including current maturities and capitalized leases) and equity. These are the funds that represent semi-permanent sources of funding for the company. The lower the ratio the better, since equity capital is a better cushion for creditors than is debt capital. The senior debt to tangible net worth plus subordinated debt ratio is one closely monitored by senior lenders. In most cases, subordinated debt very closely approximates equity. This ratio allows for an evaluation of leverage with the assumption that the subordinated debt is going to stay in the company until senior creditors are paid out.

With the data obtained from these analytical tools, a middle-market or lifestyle company's advisors can more accurately assess the company's current financial position, identify areas where the nature of the company has compromised its growth and value and provide better solutions to problems such as succession management, the feasibility of the financial forecasts, the valuation of the company and other possible corporate finance options available.

Footnotes

¹ Jim Ruane is a managing director in Huron Consulting Group's Corporate Advisory Services practice. A Certified Turnaround Professional with more than 30 years experience, he has provided turnaround and interim management assistance to numerous companies in the middle market. Return to article