From Cash Conversion to NOPAT

Owners of small businesses usually think of tax as their own. The business's profit flows through to the owner's personal return, or the owner and the business pay together in ways the accountant handles, so the question of what tax the business itself bears rarely comes up. Often nobody has asked what the business is, either. Over the years the trucks end up in one company, the building in another, the trade name in a third, and half the staff are employed by a fourth, all controlled by the same family, with money moving between them as the owner directs.

A buyer who models cash cannot work with either ambiguity. It values the business's operating profit after the business's own taxes, so it has to know what those taxes are, and it values a defined business, so it has to know where the business ends. The third span of the third bridge settles both.

What the measure is

The measure this span reaches is NOPAT, net operating profit after tax: operating profit after cash taxes at the level of the entity. The return on capital has been computed on it since the first anchor, so it is the numerator of every return the framework measures. Free cash flow to the firm is built from it, by adding back depreciation and deducting capital spending and the change in working capital.

It comes third on the bridge because it depends on the entity structure, which is usually the last thing a business looks at. It comes before the forecast because a forecast built on an uncertain tax rate and an undefined perimeter projects a business nobody could actually buy.

The two drivers

Tax Position settles what tax the operating profit bears at the level of the entity. Its centre is a memo, written with an outside tax adviser, that ties three years of cash taxes paid to the returns and the book provision and states the rate NOPAT is computed at. Where the entity passes its income through to the owner, that rate is a notional one, built and written down. Alongside it sits a study of where the business owes tax, so that it is registered and filing everywhere it should be and any past exposure is settled or quantified.

Entity Structure decides where the business stops. A structure chart shows every entity the owner or family controls that deals with the business, what each holds and why it exists. The payments between those entities go under written agreements at market rates, and the perimeter of a sale is written down, with everything the operating business needs either inside it or available to it under a written, assignable lease or licence at market.

Why a buyer assumes the worst

Where the record is silent, a buyer fills the gap with its own assumption, and that assumption is chosen to protect the buyer.

On tax, that means a high rate. A pass-through pays no tax itself, because its income is taxed on the owner's return, so a buyer who wants to value it as a taxpaying company would be valued needs a notional rate. Without a documented basis it will pick a generous one.

The framework is careful to call the result a price effect. In the illustration, a business with $1.2 million of operating profit that can document a 25 percent rate presents NOPAT of $900,000. A buyer assuming 35 percent sees $780,000, and the difference, capitalized, is about $1 million of price. Yet the business pays the same tax under either assumption, and only the buyer's model moves. The value this span creates lies elsewhere: penalties and interest avoided by registering and filing where the business should have been, exposure settled for less than it was reserved at, and operating assets brought inside the perimeter on terms that change what the business actually pays.

On the perimeter, the problem takes a different form. Trucks that sit in a family company and have been used free will have to be bought or leased by the buyer after the sale, and the buyer deducts that cost at its own figure. A trade name owned by another entity has to be acquired separately. Staff employed by a company outside the sale may not transfer at all. The buyer prices each of these gaps, and usually at the high end.

Assets or shares

The two questions meet in a decision every sale has to make: whether the buyer acquires the business's assets or the shares of the company that holds them. Lawyers and tax advisers make that choice, and it lands differently on each side, but the work on this span is needed under both.

In a sale of assets the buyer picks what it takes, from the equipment and contracts to the licences, the name and the staff it chooses to employ. The perimeter decides what is available to pick. An asset the business depends on that sits in another company is not for sale unless that company sells it too, so a business with no defined perimeter cannot even say what it is offering. The seller usually keeps the company and its history, tax history included.

In a sale of shares the buyer takes the company itself, with everything it owes. Unquantified tax exposure becomes the buyer's problem, and the buyer prices it through a lower price, money held back at closing, or an indemnity from the seller that can outlast the sale by years. A business that has settled or quantified its exposure, and can show where it files and why, gives the buyer much less to price.

Because this span answers both questions before anyone raises the form of the sale, the seller can choose the form that suits them. Without it, the state of the records tends to make the choice.

How the drivers depend on each other

The tax the business bears depends on what the business is. It turns on which entity earns the profit, which one pays for the assets, and at what price money moves between them. When the owner's tax planning sets those prices, the operating company's profit, and with it the tax, is something the owner chose. Entity Structure puts each of those flows under a written agreement at arm's length, so the operating entity's profit reflects what it does, and only then can Tax Position say what tax that profit bears.

Both drivers start from the second bridge. The intercompany flows are related-party arrangements, so the related-party schedule built under Separation is the first list to work from, and the tax reconciliation starts from the reconciliation of returns to statements built under Books. Both also need the advisers working together, because moving an asset between entities has legal and tax consequences that neither counsel nor the tax adviser should weigh alone.

How the span comes undone

Tax exposure builds in new states as the business starts selling, hiring or storing stock there, and it crosses filing thresholds nobody was watching. Meanwhile assets and contracts drift outside the perimeter, when the owner sets up a new company for a new purpose or buys equipment through whichever entity is handy, until the operating business depends on something it does not hold.

What holds the tax side is a nexus review built into each year's tax engagement, which finds a new state in the year the business crosses into it, and tax payments and notices that go to the finance seat and the adviser as well as the owner, so a letter from an unexpected state gets answered in time. On the structure side, no new entity or intercompany arrangement is created without counsel and a change to the chart, which makes the chart the place structural change has to pass through. Intercompany balances are reconciled at every close, so a payment made outside an agreement shows up as an unreconciled balance in the month it happens.

Crossing the span

The span is crossed when the tax position is understood, the entity structure holds no surprises for a buyer, and the perimeter of what is being valued is written down. The next span takes the after-tax cash the business produces and shows it can be forecast.