Why Service Providers Need to Understand Clients' Financial Metrics



By , , and


Service-Providers-Client-Metrics
Accountants and tax advisers are all familiar with the terms 'pretax earnings' and 'after-tax earnings.' However, advisers sometimes fail to perceive which measure is more relevant for business decision making for a particular client.

Understanding the differences in companies is crucial for advisers who want to provide relevant advice and get important projects approved. 

Publicly-traded Companies

Publicly-traded companies are primarily valued in the marketplace based on price-earnings multiples, which are based on pretax earnings. However, one exception lies with companies that can materially reduce income taxes compared to the other companies in the market place by techniques such as inversion to a low tax jurisdiction or achieving REIT status. These companies will be typically assigned a higher earnings multiple in the stock market. 

Many publicly traded companies (particularly those that are pretax earnings sensitive) will not authorize tax savings projects where the costs of implementation are meaningful in relation to the cash tax savings.

For example, suppose that a company trading at a multiple of 15-times pretax earnings can reduce its income taxes one time by $800,000 by spending $100,000 pretax. Although that result may strike many as a excellent cash-on-cash return, the publicly traded company may not want to experience a $1.5 million reduction in stock market value to save $800,000 in cash taxes.

Public companies that are less sensitive to pretax earnings multiples due to their long standing reputations or supportive concentrated owners are more willing to consider and implement routine tax planning (such as the above example) that not only reduces pretax earnings, but also meaningfully increases after-tax cash flow.

Note however that a publicly-traded company will typically be very open to a cost reduction project that net of project costs will enhance pretax earnings. To illustrate, using the same numbers from the above example, a project that increases pretax earnings by $100,000 adds $1.5M in firm stock market value when using a 15-times earnings multiple

Private Companies

A goal of most private companies is to increase enterprise after-tax cash flow. A company with higher overall cash flow has more capital available for all business opportunities, which may include capital expenditures, marketing, acquisitions and owner distributions.

Sticking with the figures in our example, most private companies would jump at the chance to save $800,000 in taxes for a cost of $100,000 and would most likely immediately authorize the tax project that enables them to do take advantage of this savings.

One important exception to the above scenario lies with private companies that are preparing for a business sale, particularly if the expected acquirer is a publicly-traded company. With a public company acquirer fact pattern, the purchaser tends to be willing to pay a higher multiple purchase price for a seller with higher pretax earnings that will in turn increase the purchaser's total enterprise value after the purchase.

Conclusion

In conclusion, before accountants and tax advisers attempt to have any tax and non-tax projects authorized, they need to understand the financial metrics important to their clients. The "money-saving" or "cash-flow increasing" solution isn't always the ideal one, depending on each company's financial goals.

Article Citation List

   


Authors

Charles R Goulding Attorney/CPA, is the President of R&D Tax Savers.

Jacob Goldman is the VP of Operations at R&D Tax Savers.

Raymond Kumar is a CPA and Tax Manager with R&D Tax Savers.