Key Takeaways
Revenue and EBITDA are useful starting points, but they do not fully reveal cash generation, capital requirements, or changes in business risk.
Directors should evaluate whether management is producing adequate returns on the family’s invested capital while monitoring free cash flow, working capital, leverage, liquidity, and concentration risks.
A focused scorecard, supported by relevant peer benchmarks and aligned with company strategy, helps distinguish sustainable value creation from growth that consumes capital without adequate returns.
Revenue is growing and EBITDA is up. Those results are encouraging, but they do not necessarily tell directors whether management is creating value. Revenue reflects the scale of the business, and EBITDA provides a useful measure of operating profitability. Neither measure fully captures the cash generated, the capital required to produce the results, or the risk assumed along the way.
For family business directors, the more useful question is whether management is putting the family’s capital to productive use and building long-term shareholder value.
Revenue and EBITDA Are Starting Points
Consider a company that reports 15% year-over-year revenue growth and record EBITDA. Supporting that growth required new equipment, additional inventory, longer payment terms for customers, and greater dependence on one large customer. Earnings increased, but cash flow declined, more capital was committed to the business, and the company’s risk profile increased.
Now consider a company with more modest growth that improved margins, collected receivables faster, reduced customer concentration, and generated more cash without requiring substantial investment.
The first company’s strategy may ultimately prove successful, but the current revenue and EBITDA figures alone do not reveal which company used shareholder capital more efficiently.
The gap between earnings and cash flow matters. EBITDA does not reflect the cash absorbed by inventory and receivables or the capital expenditures required to maintain and expand the business. Earnings tied up in working capital are not yet available to fund dividends, reduce debt, provide shareholder liquidity, or pursue additional investments.
At the same time, directors should not judge a long-term investment by one year’s cash flow. A new facility, technology platform, or product line may consume cash before generating an adequate return. Directors should evaluate the performance of those investments against the expectations established when the investments were approved. What was the investment expected to accomplish? What milestones were established? Has the expected return or risk profile changed?
Measure Returns on the Family’s Capital
Management creates value when the returns generated by the business justify the capital committed and the risks assumed. That relationship is particularly important in a family business, where shareholders often hold a substantial portion of their wealth in a single, illiquid investment.
A useful performance scorecard should connect operating results to cash flow, capital efficiency, and risk. The exact measures will vary by company, but these categories provide a practical starting point.
Cash generation. Free cash flow shows how much cash remains after funding the operating and capital needs of the business. Working-capital measures can reveal whether growth is generating cash or consuming it.
Returns on capital. Return on invested capital helps directors assess whether the business is earning an adequate return on the capital retained and reinvested in the company. It also provides a useful reference point for comparing returns earned in the business with other potential uses of family capital.
Risk. Higher earnings do not necessarily lead to increased shareholder value. Changes in risk can mitigate or amplify changes in the value of a business. Directors should identify and monitor metrics correlated with the risk of the family business. Financial leverage and liquidity, customer concentration, and supplier dependencies are common risk factors, but managers and directors should regularly discuss other sources of risk for the family business and strategies available to mitigate those risks.
Use Benchmarks to Ask Better Questions
Budget comparisons and prior-year results are useful, but relevant peer benchmarks can help directors determine whether performance trends are unique to the company or common to the industry.
If the company’s margins are declining while peer margins are stable, the board might examine pricing, product mix, or cost control. If working capital requirements are materially higher than those of comparable businesses, directors should consider whether the difference reflects the company’s strategy or an operating problem.
Industry averages and peer results are reference points, not automatic targets. A company may trail its peers at a point in time because it is investing in future growth. It may also outperform by accepting risks that do not fit the family’s objectives. The board’s task is to understand why the company’s performance differs from its peers and whether the variances are consistent with the company’s strategy.
Keep the Scorecard Focused
More metrics do not necessarily produce better oversight. A long dashboard can obscure performance as easily as an incomplete one. Directors need a focused scorecard that answers four questions:
Is management executing the strategy?
Is the business converting earnings into cash?
Are investments producing adequate returns?
Is the company’s risk profile consistent with the family’s objectives?
Revenue and EBITDA remain important and are most useful when considered alongside other metrics that help directors assess cash generation, capital efficiency, and risk. A focused scorecard, tied to the company’s strategy and informed by relevant benchmarks, helps directors distinguish sustainable value creation from growth that consumes capital without producing adequate returns.