Could I suggest two helpful financial indicators of your business performance that apply whether you own a small fashion boutique in Paddington, a menswear outlet in a shopping centre, or are a major fashion supplier? They also provide a good measure of the value of your business, are frequently used by the banks to assess your loan applications and creditworthiness, and, more importantly, enable you to assess how well your business is going compared to others. Unfortunately they have titles that are not very user-friendly. So I would like to demystify these two measures.
Measure one. EBIT – Earnings before interest and tax.
The profit shown on your tax return is often a poor measure of your business performance because it often includes ‘non-business’ items (quite legitimately) to reduce your tax, such as extra superannuation contributions, non-commercial owner’s wages and rent, director’s fees, etc. To assess business performance, you need to correct/exclude such items. You also need to exclude interest and tax because they are indicators of how you fund your business and of your business/personal tax arrangements. They are important in assessing your cash position, but not business performance.
Hence the term earnings before interest and tax (EBIT), which can be shown simply as:
• Sales Revenue - $900,000 - 100%
• Less Business expenses (exclude interest) - $720,000 - 80%
• Equals EBIT - $180,000 - 20%
How is knowing your EBIT helpful?
1.EBIT as a percentage of turnover provides you with a basis for comparing your business performance with others without disclosing confidential information.
So in the above example this business makes an EBIT of 20 per cent, or 20 cents for every dollar of revenue. This EBIT percentage will vary from business to business, but as a general rule of thumb 10 per cent to 15 per cent is an indicative minimum target in the fashion industry. Keep in mind that the EBIT is after including a wage/salary for working owners.
How does your business EBIT shape up?
If, for example, you’re EBIT is seven per cent on a turnover of $1 million ($70,000), whereas another fashion retailer (for example) is achieving an EBIT of 15 per cent ($150,000) on a similar turnover, then you perhaps need to be more closely analysing your business model/approach. $80,000 is a significant difference in profit on the same turnover. Having just completed a major benchmark study for a fashion group, this sort of variation in EBIT percentages among similar businesses is not uncommon, and indicates the need for closer management attention.
2.EBIT is also the initial indicator of the value of your business.
The common approach in valuing a retail business today is to apply a multiple of usually between 2.5 and 3.5 to your EBIT to get a ballpark valuation of your business. So, for example, if you’re EBIT is $80,000 and we apply a multiple of three, then the initial valuation of your business would be $240,000. Keep in mind that this covers everything, including stock! Of course, there are other factors that can influence this valuation, but it is helpful as an owner to understand where the starting point is. If you compare this ballpark valuation with, say, the value of the main assets of your business (primarily stock), or even your own view of its worth, it can assist you to reassess how your business is really performing.
One of the biggest challenges for most fashion businesses is to raise their EBIT to a level that provides a fair business return relative to the stock and the owners’ investment. Unfortunately, this is usually not the case, and is why many businesses just sell for the value of the discounted stock.
3.EBIT is also commonly used by banks as an indicator of your ability to generate cash from the business.
Are you able to meet your funding (loan P & I) and tax commitments from the EBIT? It is a good measure to start being realistic about your financial commitments in the business.
Stay tuned for the next chapter on Return On Capital Employed (ROCE).
Brett Stevenson is Director of Excellere Pty Ltd, a company that specialises in workshops covering financial and strategic management. www.excellere.com.au