Business Valuations Uncover Hidden Cash Flow
Planning Offers Big Returns
Most business owners do not carefully prepare their business for sale. Rather, most business owners simply sell when it is about time to sell. Many business owners spend a lifetime building their business but do not plan for the biggest sale of their life. Savvy buyers look for companies with sustainable competitive advantages and good growth potential, where improved operations can add significant dollars in cash flow and enterprise value. Why sell to someone who can make more money in a few years than you did over twenty years?
As business owners near retirement age, the value of their business becomes more and more important. Research suggests that approximately 45% of business owners could sell their business and maintain their current lifestyle. Simply the business owners can’t replace the income stream that their present business provides them. After paying taxes and reinvesting the sale proceeds, it is difficult to earn a higher return on their investment that they have been used to.
Lessen Your Financial Risk
Legendary football coach Bear Bryant remarked, “offense sells tickets, defense wins championships”. Bear Bryant won a lot of championships at Alabama by focusing on defensive strategies. Defensive strategies reduce future risk, improving the likelihood of success. Business is all about mitigating risk as much as possible.
First, let us define the financial business risk. Ultimately the biggest financial risk to a company is when revenues over time, do not generate enough cash to pay debts in a timely manner and the company’s future is restricted or is even in jeopardy. Some companies may not have the cash required to expand their business as planned which may present future competitive risk. Companies can often borrow money to cover cash needs, however, at some point, the interest and loan principal needs to be repaid.
Analytical valuations can be your roadmap to more wealth creation
The best way for a company to reduce the risk presented by lower than desirable cash flows is to isolate the areas reducing the cash flow and implement changes to optimize future performance, cash flow, and the company’s ability to compete in the future. After all, a company with a healthy and optimal cash flow has much less financial risk than a company with negative, marginal, or lower than desired cash flows. Higher cash flows do promote a company’s long-term success rate … and a business valuation can be a financial roadmap to financial security.
A detailed and analytical valuation identifies the areas that present the greatest opportunities to improve cash flow. The most significant asset companies tend to overlook is their own data. Pertinent data lays the foundation to develop great insights and actionable strategies. Good companies continually improve their financial performance by reviewing their financial data and by constantly acting on this vital information. An analytical valuation is valuable in assessing additional opportunities.
Profit is an accounting term that tells only part of the story
Before we continue, let us talk about how profit is different from cash flow and how companies experience liquidity challenges. We have heard of profitable companies that filed for protection under the bankruptcy code. I worked with a few of these companies which made a profit but did not have the available cash to pay their debts. These companies became illiquid and insolvent. Profit is an accounting term found on the Income Statement that is the outcome of matching and timing revenue and expenses. After deducting all expenses (Cost of Goods Sold and Operating Expenses) from revenues, the result is in an operating profit or loss. The Primary Cash Drivers from the Income Statement are Sales, Cost of Goods Sold, and the Operating Expenses (Selling, General, and Administrative Expenses). These three Cash Drivers produce an operating profit or loss which then flows into the Balance Sheet as Retained Earnings. A company’s aggregate of profits over the years are accumulated in Retained Earnings under Stockholders’ Equity. Revenues and expenses impact cash flow and the Balance Sheet changes can significantly impact cash flow also. Let’s continue with the profitable companies that were insolvent and look at the Secondary Cash Drivers that impact liquidity.
Generate more cash to reduce debt, invest in the business, or take it home
Companies need to invest in their business to finance sales. No matter what industry you operate in, the company may need to fund sales in the form of Accounts Receivables, inventory, and payables. To sell a product, the company agrees to bill the customer and collect the receivable on a set time schedule. The company may purchase supplies from vendors and pay for these Account Payables in a certain amount of time and many businesses invest in Inventory (ready to sell the product, any associated labor, overhead, and material cost). Typically, as a company grows, Receivables, Inventory, and Payables will also grow. Therefore growth companies either need equity investments or very good banking relationships.
The Receivables, Inventory, and Payables are considered the Secondary Cash Drivers which are Current Accounts on the Balance Sheet. A company directly impacts these secondary cash drivers by how they manage their Receivables and Inventory as well as managing the Payables. The more a company can efficiently manage these Balance Sheet Cash Drivers, the more cash is available to operate the business and pay its debt obligations. This cash investment is called the Cash Cycle or the Cash Conversion Cycle (AR Days + Inventory Days – Payable Days) which is the time it takes from the time cash is invested to when the cash is collected.
Do you want reports or insight?
A strategic valuation can review the company’s resources and isolate exactly what inefficiencies are costing the company in cash and enterprise value. A close review of the past net cash flow and a forecast of how the next 3 to five years of net cash flow become the financial roadmap to greater cash Risk mitigation translates into improved profit, cash flow, and enterprise value. To paraphrase Bear Bryant, sales and profit can win games, but it is cash flow that wins championships and allows companies to thrive.
According to a recent Wall Street Journal article, companies that use analytics have more cost discipline and deliver an average 5.9% return premium over their peer competitors that do not use analytics. Businesses that generate more insight were better at extrapolating trends and had better cost management disciplines. A good valuation can offer not only good reporting but solid insight.