How to calculate and manage your TNW to a level that is sufficient to meet your business’ capital needs for growth.
Most agents understand that the value of their agencies lie in the value of the book of business – the future revenues and earnings derived from policy renewals and to collecting commissions and fees from those accounts. Any sale of an agency will be, in great part, the “soft” value of future earnings. However, if an agency is sold as a corporation instead of being sold as a book of business, the value of the agency’s balance sheet must be included in the valuation of an agency.
The ‘hard’ value of a business is in its Tangible Net Worth (TNW). TNW is defined as total equity less any intangible assets (like renewals/expirations purchased, non-compete agreement values, and other goodwill). If you look at your Balance Sheet and take the Total Equity and subtract the intangible assets from your asset section, you will derive your TNW.
Most corporations in the U.S. strive to build a TNW that is sufficient to meet their future capital needs (acquisitions, hiring new people, evolving new products and services). Capital needs require sufficient worth to sponsor those investments.
Unfortunately, most insurance agencies, while corporations in structure, tend to run with the owners stripping all remaining profits from the business each year, always under the assumption that if the business needs money, they will provide the cash from other sources. The reality is that, lacking excess TNW, many agencies simply DON’T make the investments that the business requires to continue its growth.
Most agencies provide their owners a good living and work with very little TNW or Working Capital.
Working Capital is defined as “Current Assets – Current Liabilities” and this term defines how much cash (and cash equivalents like Receivables) you have on hand to meet your regular on-going cash obligations (i.e. payroll, company payables, and normal agency bills every month).
If you find yourself struggling every month to collect your receivables and eagerly await your commission checks simply to make your payroll and pay your bills, you probably have insufficient Working Capital.
A healthy insurance agency will have at least 30 days of Working Capital in order to assure that they always have sufficient cash on hand to meet normal obligations without causing the accounting department or the owner sleepless nights and undue stress. The calculation of how much Working Capital you need is done by taking all of the annual expenses in your agency and subtracting non-cash expenses (like depreciation, amortization and bad debts). Divide the sum derived by 365 and you have your average daily cash needs. Multiply that amount by 30 days to see your “30 Day WC Requirement”.
Now, if you calculate your actual working capital (Current Assets – Current Liabilities) and compare it against your 30 Day Requirement, you will quickly see if you have sufficient WC to satisfy your normal business requirements.
Of course, I’m a master at stating the obvious! If you have trouble paying your bills every month, you don’t need to do balance sheet calculations to know you have a cash problem. However, the measurement of WC will tell you how short or how flush you are in that area. While not as bad as agencies with constant cash shortages, some agencies have so much WC that they build very strong TNW positions. If they have capital needs that require substantial cash reserves, this is a good thing. However, most agencies with substantial cash have no plans or needs for that cash besides making the owners feel good that they are fiscally conservative with a strong balance sheet.
If you are well off personally, having a strong TNW position is not a bad thing. TNW adds dollar-for-dollar value to your business. But if you have personal financial needs and still keep a very strong corporate balance sheet for the sake of conservatism, you must be reminded that your business is meant to provide you and your family a comfortable lifestyle. You should never go wanting for personal security and comfort simply because you “might” need additional cash in your business someday.
The measurement of TNW and Working Capital is one method of determining if your business is financially stable. A WC of 30 days or more is considered healthy. You don’t worry every month about paying your bills. A weak WC (less than 30 days) actually affects your agency’s value.
If a buyer purchases your agency, he will have to pay your normal bills during the first months of his tenure as owner until the normal revenues of your agency are received. If he buys your corporation, that includes your cash on hand (WC). If it is less than 30 days, the buyer’s accountant will advise him that he will need sufficient additional cash to pay the bills in the first month. It is likely that the calculation of value will include a factor for any additional Working Capital needs if insufficient WC remains in the corporation to pay the next month’s bills. This will reduce the value of your agency by the difference between the agency’s actual cash value and the 30 day requirement.
If a buyer purchases your agency as an asset purchase, you get to keep your corporation and all of the TNW and cash that you have built. However, the buyer’s accountant will still advise him to lower the value he is paying for the agency by a 30 day Working Capital requirement to reserve sufficient of his cash to pay the bills in the first month.
If agencies are flush with cash and have both strong WC positions and strong TNW values, the value of the agency’s corporate purchase will reflect a dollar-for-dollar increase in the value of the TNW. No further adjustments will be made because the excess WC will be a part of the TNW and will have already accrued to the seller’s additional value.
We urge you to calculate and manage your TNW to a level that is sufficient to meet your business’ capital needs for growth in the future. Manage your WC to eliminate the stress and sleepless nights worrying about how to pay your bills. Manage both to maximize your value when the time comes to sell either the corporation or the assets to the next generation of owners.