American short-story writer and novelist F Scott Fitzgerald is best known for his at times turbulent personal life and his famous novel The Great Gatsby. He is also known for this quote:
“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function. One should, for example, be able to see things as hopeless and yet be determined to make them otherwise.”
The quote came to mind recently when I attended a management rights industry gathering where the subject of accounting verification and financial reporting came up. Truly a diverse and, at times, bazaar range of views emerged with a brisk and, at times, emotional debate ensuing. The two key points that seemed to have the minds of those in attendance focused were the use of more than a single trading year profit and loss when selling and what to include and exclude by way of income.
Let’s cut to the chase. Management rights is, so far as I know, the only going concern business sold on a single year’s profit and loss and certainly the only one that the banks are comfortable to fund on this basis. There seems to be a view in some quarters that having more than a single year might be a good thing.
Certainly if I were purchasing a management rights and had two to choose from I would be inclined to favour the one with historical trading statements and a few years profit and loss records. As a valuer of my acquaintance puts it, certainty equals value and on that basis historical trading figures equals a higher value than an absence thereof.
However, experience suggests there is a trap in this logic. If one year’s P&L is good than surely two years must be better. Sadly this is rarely the case. In assessing the performance of any business a potential purchaser will look for trends and benchmarks. The accepted wisdom in the banking and accounting fields that three years records is best has taken hold for a reason. More often than not two years figures will create more questions and uncertainty than they answer. In my view either rely on a single year or get three years financials whenever possible. It is only with a third year that trends can be seen in the context of a reasonable operating period and any anomalies ironed out.
I have firsthand experience of these matters within the motel industry where three years financials is pretty much the industry standard. Having benchmarks over three consecutive accounting periods allows purchasers to make informed decisions in regard to trends and likely future operating performance. For example, I recently saw two years figures for a motel that indicated that the business gross revenues and net profit were in free-fall. Scared the hell out of the buyer so we went back three years and discovered that the most recent performance was pretty much the historical average for the business. A particularly good but unsustainable business performance two years ago had made the whole trend line look ugly but with the benchmark reference of further historical data the purchase went ahead.
I acknowledge that management rights are by their very nature different to any other type of business and frankly I can’t see much wrong with the current system of using only the most recent P&L for sale purposes. However, if the industry decides to move to sales predicated on more comprehensive historical financial statements best to get it right the first time.
And now to play contrarian! Defined by Wikipedia as a person who takes up a contrary position, especially a position that is opposed to that of the majority, regardless of how unpopular it may be. Contrarian styles of argument and disagreement have historically been associated with radicalism and dissent. So, in other words a good old Aussie stirrer. Here’s a bit of food for thought. What exactly should be included in the income for a management rights and what should be excluded?
Traditionally there have been income streams that are, by their nature, excluded from the income for sale purposes within the management rights industry. A prime example is sales commission earned by the resident manager on sale of units within a building. I’ve started to wonder if this is a reasonable approach or if a better test of acceptable income might be available.
How’s this sound? What if the test was predicated on income that vested with the resident manager due to the fact that the manager occupied a position within the business that no other party could occupy? In other words the income was clearly linked to the exclusive and unique position held by the resident manager.
So, if a resident manager, due to relationships with owners and guests, is able to sell units in a building at a competitive advantage to other real estate agents should that sales commission income be included in the P&L for sale purposes? If so what multiple should apply to that part of net profit? What about external letting appointments and/or caretaking picked up simply because the resident manager is on site, conveniently located and the unmanaged building next door has no resident manager or local caretaking services.
One thing is clear. If you can show via three years financial statements that some of these income streams are reliable then I am sure the market will pay a premium even if the income is not included in the P&L for sale purposes.
I shall leave with the words of Winston Churchill : “To improve is to change; to be perfect is to change often.”
Ha ha…you were expecting, “We will fight them on the beaches.”
Image: F Scott Fitzgerald
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