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Why Agencies Should Focus on Cash Flow

Smart agency owners recognize that cash flow is a better determinant of value than revenue. When analyzing cash flow, every owner should pay attention to two important considerations.
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In the great debate over agency valuation, words like “revenue,” “income” and “profit” get tossed around a lot. On the golf course or at industry meetings, owners speak in whispers about the big ones—the agencies that have sold at seemingly impossible multiples.

The question is: Multiples of what? What’s the value driver?

Often, it’s the agency’s “book” that everyone’s talking about. But revenue isn’t always the best measure of agency value, nor is it what principals should be concerned about if they’re trying to grow their business or sell their firm.

Rather than focusing on top-line revenue, smart agency owners recognize that cash flow is a better determinant of value. And increasing value should always be the No. 1 goal to sell or perpetuate your business.

The chief problem with using revenue as a measure of value is that it doesn’t take into account the cost of generating income. Not all revenue dollars are created equal. Spending a dollar to make a dollar is not a very efficient operation. Cash flow is a much better indicator of the quality of an agency’s earning power.

What is cash flow, exactly? Some equate it to EBITDA (earnings before interest, tax, depreciation and amortization), and that’s a good start since earnings are what you get to after you’ve subtracted all your expenses.

When analyzing those earnings there are two important considerations that every owner should pay attention to:

1. The quality of your cash flow.

2. Any future risks that may affect your earning power.

What’s The Quality of Your Cash Flow?

Essentially, acquirers are looking for streams of cash flow that are predictable into the future. This is the magic of the independent agency system—it generates a recurring stream of cash that can be taken to the bank year after year. Very few businesses can consistently deliver value like an insurance agency, which is what makes the model so attractive and why there is such a demand for agencies.

How do you make your cash flow predictable? Through continual, steady growth that adds value to your agency.

Your goal shouldn’t simply be to earn more commission income. It should be to increase your cash flow over time. Every business decision you make needs to contribute to your bottom line. That’s what truly drives value.

The advice you so often hear—“Just sell more”—doesn’t necessarily lead to growth. If it costs more to sell more, the net result may be lots of effort for very little return. You may have a bigger agency with more employees, but you haven’t maximized your value.

Growth comes through a combination of investing in new sources of income, like hiring another producer or adding lines of business, and greater efficiency. The two go hand in hand. When income can be earned with fewer expenses, it increases your cash flow and your agency’s value.

Reducing the cost of servicing accounts over time by upgrading your computer and phone systems, utilizing the latest agency management software to better market and cross-sell, digitizing your records, using your cash more efficiently, getting known on social media—these are all ways you can increase your productivity and maximize your selling ability.

What’s The Risk to Your Cash Flow?

Remember, your cash flow must be predictable into the future. A buyer will look beyond EBITDA to understand the source of your cash flow and its volatility or risk. What’s the risk of those earnings diminishing in future years?

The indicators here might be historical trends in retention and loss ratios, the geographic location of your agency (is the population declining or aging?), the market you are in, the companies you represent and the types of customers you serve.

Retention is one of the key ingredients in the secret sauce of sustainable cash flow. The higher the retention rate, the greater the potential you have for future earnings. Renewal sales are always more profitable than new sales since they require less production expense. On the other hand, life sales are often discounted because they don’t produce much in future revenue.

Quality and Risk

Are your customers getting ready to retire and move to Florida? Are your producers all the same age, and will they be retiring soon, too? What about contingencies, which are a less reliable stream of revenue?

How many more years do you want to stay active in the business? Assuming you have five to 10 years left or more, use those years to grow your business. At the same time, begin to consider ways to perpetuate your agency by grooming a successor.

Keep these factors in mind and make them a part of your strategic planning. It may mean exploring new markets, hiring younger producers or acquiring another agency that complements your business.

It’s helpful to look at industry benchmarks to see how top agencies are performing in areas such as revenue per employee, efficiency ratios and growth percentages. Obviously, higher-performing agencies will command premium prices when it’s time to sell, much like the best house in your neighborhood will go to the highest bidder.

By taking the long view and steadily building value in your agency, you’ll be able to retire comfortably and leave a lasting legacy to your family or partners. The important thing is to have a plan and to work it during your productive years.

Keep in mind the true drivers of value and stay focused on them. Understand that cash flow will trump revenue every time.

David Tralka is the president and CEO of InsurBanc. He is responsible for keeping the bank focused on being an innovative provider of financial products and services for the independent agency community. An expert on agency mergers & acquisitions, agency perpetuation and financing, he has presented at numerous venues nationwide.

Tuesday, June 2, 2020
Agency Operations & Best Practices