Considerable confusion seems to exist within many agency owner networking groups regarding accounting, cash flow, agency value, and income statements. Hopefully I can clear up some of the haziness.
First and foremost, high quality financial statements are required in order for your business to be in compliance. An accountant told me the other day that high quality financial statements are not required for small businesses like most agencies. A state association director told an agent they did not need a quality agency appraisal because that would require quality financial statements. Both should be straight out fired. One key to quality financial statements is to hire professional financial advisors as these people were not quality financial advisors.
Another key to quality financial statements is a quality accounting system. QuickBooks generally will not work for agency bill accounts without significant user knowledge and manipulation. Even if the income statement is somehow correct, the balance sheets will almost certainly be materially wrong.
Next, you MUST have a balance sheet. I have seen quite a few agencies acknowledge QuickBooks will not generate a correct balance sheet, so they just do not have balance sheets. That is not a solution. Your agency may be small enough and/or lucky enough to operate without a balance sheet for years, but eventually you must provide an accurate balance sheet when you go to sell, get a loan, or have some other transaction (at least if the other party is knowledgeable about insurance agencies). You want a lender that knows what they are doing because if a loan goes south that they should never have made, they likely will not take responsibility for making a bad loan. Instead, they may accuse you of fraudulently applying for the loan, something that cost one agency I know around $500,000 in legal bills. States do not often audit agencies anymore, but if the state does request an audit, you will need a balance sheet.
Next, cash flow is not income. Income is taxed. Cash flow is post tax. EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) is close to cash flow but not quite. If you are repaying a loan, cash flow will include the loan payments (or if you've made a loan and are receiving payments), but EBITDA will not. This is just one material difference. When borrowing money or buying or selling an agency, one had better have accurate cash flow and income numbers.
Cash flow adds loans, amortization, and depreciation while subtracting loan payments and taxes (on a simplified basis). EBITDA also adds back depreciation and amortization, but also adds back taxes and interest. EBITDA does not address loan principal payments.
Income is revenue less expenses excluding income taxes or including taxes depending on the statement. Owners may pay distributions on their income, probably post tax, but only idiots and private equity pay distributions on income if loan payments are involved. Instead, they pay distributions based on cash flow.
The only people to spend EBITDA are PE (Private Equity) and publicly traded companies trading on an arbitrage basis their EBITDA.
Here is a real example of an agency that did not know better and messed up royally. The agency paid two times revenue to acquire another agency. The seller's balance sheet was short a material amount of cash that had to be recovered. The buyer had to make up the difference. Cash flow was about 10% of revenue, excluding the buyer's loan. The net cash flow post-deal was about -15% per year. Keep in mind, one pays taxes on profit. Profit is used to make principal loan payments.
The agency’s owner did not understand that real honest valuations are based on future forecasted cash flow and the risk that cash flow will diminish due to something going wrong. If a deal does not show cash flow, not income flow but cash flow, and you are spending your own money, you might want to walk away.
Making the deal even worse, the agency wanted the former owner to work for free or at least for much less than normal commissions. Ask your tax attorney but working for free is almost certainly illegal because it violates the IRS's Reasonable Compensation Rules.
These compensation rules are pretty basic. Everyone is supposed to get paid the same for the same job. Therefore, if producers are paid 40/40, then the ex-owner should be paid 40/40 too. This is a reasonable rule. People should get paid equally and people should not work for free.
One reason these rules exist is to collect taxes. By not paying commissions, no one pays employment taxes. The IRS and DOL do not appreciate people not paying their taxes. Not paying your taxes also creates other potential EPL exposures and is generally therefore, just a bad idea.
However, the agency completed the deal and has since discovered the numbers do not work. Attorneys do not do math so they did not catch the problem when they wrote the contract. Everyone signed the contract. What can the agency do now?
The level of understanding and possession of quality financial statements seems to be in decline with so many start up agencies. I strongly encourage all agency owners to at least take a basic financial accounting class. Years ago, I did a video series on agency financial management for the Insurance Academy. I think it is still available. Some of the data is dated, but the fundamentals have not changed. I do not know what they charge for the series.
Understanding cash flow and income and EBITDA will also enable you to be a better insurance advisor to your clients, especially for critical coverages like business income and cyber business income. These coverages cannot be sold correctly without the seller, i.e., the agent, understanding income and cash flow while working with their client to calculate the best solution.
Another reason to possess this knowledge is to protect yourself against incompetent advisors. I recently reviewed an agency with obscenely bad income statement numbers. Neither their insurance agency consultant (who reviewed their financials 30 times in 15 years), nor their CPA had said anything to them about the problem. My review was a complete surprise and given the circumstances, it was not a good time for a surprise.
Get a financial education to protect yourself against yourself, faux advisors, and help your clients better understand the business income coverages they truly need.
NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.
None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.