More "GAHAP"

January 9, 2008

Our CEO said “so when will our next blog post on GAHAP come out?” By GAHAP he means “generally accepted hosting accounting principles.” He asked for it, so you get it :). If GAHAP bores you, try this on your iPhone. It’s fun!

I could probably squeeze everyone left reading at this point in a Dodge Viper and we could discuss this over lunch. But SL doesn’t provide Vipers to executives so I guess I’ll post it here for you. A balance sheet by definition is a snapshot of the current financial condition of a company. Here's a formal definition. A GAAP balance sheet simply doesn’t portray an accurate picture of the financial condition of a hosting company.

Probably the most important value that a GAAP balance sheet completely misses is the value produced by monthly recurring revenue. By implementing some sort of fair value accounting as I mentioned before this value gets captured. But on that part of the balance sheet, it still doesn’t help someone looking at the dreaded current ratio. So here’s a way to get a measure of this value that matches up to current liabilities on the balance sheet and get a current ratio that better reflects the company’s true financial position.

Since current liabilities include debt that must be paid at any time over the next 12 months, I would propose using statistics to walk forward 12 months and add “Future EBITDA from Existing Customers” as a current asset on the balance sheet. I can sense the shudders of all accountants who are reading this because you’re thinking that this completely abandons the revered principle of conservatism. In hosting, however, this can be done with conservatism in mind by employing statistics. Public accounting auditors employ statistics every day in their work, so the use of statistics is not a foreign concept to accountants.

Here’s how I’d propose hosting companies do this. First, look at the behavior of the current customer base at the beginning of each month regarding customer churn and the purchase of incremental business by remaining customers. Ignore all new customers acquired during the month and add them to the customer base for next month’s analysis. For each month over the past 12 months, analyze how much revenue is lost from customers who leave and net that from how much revenue is recognized from the existing customers who remain. The results of this analysis can be statistically boiled down to give you an idea of how much revenue will come in over the next 12 months even if you do not gain a single new customer during the next 12 months. That’s the principle of conservatism coming into play here. Let’s call this “statistically stable anticipated revenue.” By the way, at SoftLayer, the incremental business from customers who stay is greater than the business lost from customers who leave us.

Second, take a look at EBITDA margins over the past 12 months and work the statistical mojo to get an idea of EBITDA margins going forward. Multiply this margin against the statistically stable anticipated revenue to arrive at “Future EBITDA from Existing Customers.”

Third, add this category as a new line in the Current Assets portion of the balance sheet as well as adding it as a new line in the Stockholder’s Equity portion of the balance sheet. The resulting balance sheet is much closer to the true financial condition of a hosting company than a traditional GAAP balance sheet.

Why is this view more accurate? 1) A hosting company isn’t like a retail store. Like a hosting company, retail stores have repeat customers but the repeat behavior is more sporadic. The customer may decide that the weather is too bad and they’ll run out and get that new pair of shoes another day. Or the weekend may have been too hectic for a grocery store run so they’ll eat out for the next week. With hosting customers, mission-critical things live on their servers and they are usually set up on automatic monthly billings. Repeat sales are much more predictable than for customers of retail stores. This consistent cash flow has real value, and to not capture it on the balance sheet negatively distorts the financial condition of the company. 2) Putting this statistically solid future EBITDA as a current asset allows a better picture of the current ratio because it is from this EBITDA that the current portion of the company’s debt will be paid. This gives a banker, etc., a clear view of whether the company will struggle over the next year to pay them back.

Here’s how a sample summary balance sheet would look before and after this adjustment.

                                                  <b>GAAP</b>            <b>"GAHAP"</b>
Cash, A/R, Other Current Assets                $33,218,805     $33,218,805
Future EBITDA from Existing Customers        <u>           $0     $26,575,044</u>
Total Current Assets                           $33,218,805     $59,793,849 
 
Fixed Assets                                   $90,355,150     $90,355,150
Other Assets                                    $9,301,265      $9,301,265
                                             =============================
<strong>Total Assets</strong>                                  $132,875,221    $159,450,265 
 
Current Liabilities                            $55,807,593     $55,807,593
<strong>Long Term Liabilities</strong>                          $67,766,363     $67,766,363 
 
Stock, Paid in Capital, Retained Earnings       $9,301,265      $9,301,265
Future EBITDA from Existing Customers        <u>           $0     $26,575,044</u>
<strong>Total Stockholder's Equity</strong>                      $9,301,265     $35,876,310
                                             =============================                                                                                   
<strong>Total Liabilities and Stockholder's Equity</strong>    $132,875,221    $159,450,265 
 
Current Ratio                                         0.60            1.07

-Gary

Comments

January 11th, 2008 at 4:55am

I'm an accountant, but also enjoy the odd financial analysis and have some clients for whom I just do financial analysis. The above is really spot on. And often contract/staffing analysis and other more management style reporting is more useful then GAAP internally. We need more CMA style accountants in addition to the CPA's, who I've found take a very audit orientated approach to things even internally where there is a clear skew. It's nice to run into more broadly minded analytical CPA. I especially how you parallel the current liabilities definition.

One quick point, but current liabilities is not a strict 12 months but can include liabilities that are settled for cash or equivalents beyond a year (pretty industry dependent). I beleive the formal defintion references a year or operating cycle, whichever is longer. In the hosting business, your operating cycle is probably much much shorter then a year, so an irrelevant point in the GAHAP world :)

That said, for comparison purposes across companies, GAAP is absolutely critical, because you make all the adjustments on a post GAAP bases, or set benchmarks/hurdle rates etc differently given a specific sector. Not as good as an internal management report, but doable.

Look forward to the next GAHAP update...

January 25th, 2008 at 1:23pm

This is great info:

Do you have a simple calculation that can be used in hosting /dedicated server hosting to give us an idea or ballpark number of the avg income per customer?

Trying to find out our income (not counting costs) per customer for marketing budgets.

March 7th, 2008 at 2:11pm

augustz,

Thanks for your comments. Sorry I haven't had a chance to respond sooner. You are right on the operating cycle vs. 1 year, whichever is longer, and also correct that our operating cycle is less than a year, so I didn't even bring that up in our current liabilities discussion. :)

On comparing across companies, it is possible for an industry to adopt a standard that is unique to that business. Consider real estate investment management - that industry values buildings at fair market value, not historical cost less accumulated depreciation. Hosting is a WAY smaller industry but I have faint hopes that someday we can tweak our accounting standards for our industry in a few ways that make common sense.

March 7th, 2008 at 2:17pm

g00gle,

Also, sorry for not getting back to you sooner. When you say "income (not counting costs)" I'm guessing you mean top line revenue. I could tell you our average revenue per customer, but then Lance would whack me or something :)

There are a few ways to calculate what you're looking for. A simple way would be to divide your total revenue by total number of customers to get the average per customer. Or if you know the average price of a unit sold and how many units are held per customer, then multiply the average unit price times the units held per customer to get what you're looking for.

Gary

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Comments

January 11th, 2008 at 4:55am

I'm an accountant, but also enjoy the odd financial analysis and have some clients for whom I just do financial analysis. The above is really spot on. And often contract/staffing analysis and other more management style reporting is more useful then GAAP internally. We need more CMA style accountants in addition to the CPA's, who I've found take a very audit orientated approach to things even internally where there is a clear skew. It's nice to run into more broadly minded analytical CPA. I especially how you parallel the current liabilities definition.

One quick point, but current liabilities is not a strict 12 months but can include liabilities that are settled for cash or equivalents beyond a year (pretty industry dependent). I beleive the formal defintion references a year or operating cycle, whichever is longer. In the hosting business, your operating cycle is probably much much shorter then a year, so an irrelevant point in the GAHAP world :)

That said, for comparison purposes across companies, GAAP is absolutely critical, because you make all the adjustments on a post GAAP bases, or set benchmarks/hurdle rates etc differently given a specific sector. Not as good as an internal management report, but doable.

Look forward to the next GAHAP update...

January 25th, 2008 at 1:23pm

This is great info:

Do you have a simple calculation that can be used in hosting /dedicated server hosting to give us an idea or ballpark number of the avg income per customer?

Trying to find out our income (not counting costs) per customer for marketing budgets.

March 7th, 2008 at 2:11pm

augustz,

Thanks for your comments. Sorry I haven't had a chance to respond sooner. You are right on the operating cycle vs. 1 year, whichever is longer, and also correct that our operating cycle is less than a year, so I didn't even bring that up in our current liabilities discussion. :)

On comparing across companies, it is possible for an industry to adopt a standard that is unique to that business. Consider real estate investment management - that industry values buildings at fair market value, not historical cost less accumulated depreciation. Hosting is a WAY smaller industry but I have faint hopes that someday we can tweak our accounting standards for our industry in a few ways that make common sense.

March 7th, 2008 at 2:17pm

g00gle,

Also, sorry for not getting back to you sooner. When you say "income (not counting costs)" I'm guessing you mean top line revenue. I could tell you our average revenue per customer, but then Lance would whack me or something :)

There are a few ways to calculate what you're looking for. A simple way would be to divide your total revenue by total number of customers to get the average per customer. Or if you know the average price of a unit sold and how many units are held per customer, then multiply the average unit price times the units held per customer to get what you're looking for.

Gary

Leave a Reply

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