Figuring Out Profitability From Gross Sales And Expenses Taxes Formula Cash Flow and Business Valuation

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Cash Flow and Business Valuation

When business owners and their financial advisors review a firm for acquisition purposes one of their main goals is to assess ‘cash flow’. A business generates cash flow from three sources:

their operations/profits

Business is investment in business

Borrowing activities

When assessing cash flow a business owner, or their advisor is actually going through the 5 key areas of business cash flow. Those areas are as follows:

1. Reviewing the Income Statement

2. Analyzing what cash needs to be spent on new equipment, plant, etc

3. Checking the overall working capital position

4. Determining Total Annual Cash Flows

5. Putting a value on those future cash flows

Where does the acquirer start in this whole process? The income statement is carefully reviewed with respect to gross profit margin and good net income. After determining that final net income number, the analyst ‘adds back’ the amount of depreciation the company took, since it was not an actual cash outlay.

This leaves us with a somewhat ‘magic number’ – aka​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​ (Earnings before interest and taxes)

The income statement is carefully analyzed – all the basics are reviewed: sales targets, material costs, profits, and administrative expenses. As the business owner is investing in the future of buying a firm, the above analysis is usually done for 3-5 years.

Then we look carefully at all the equipment (point 2 above) and determine the useful life and replacement requirements.

Item 3 brings us to working capital analysis. As sales increase we need to carry more inventory and receivables, what our suppliers will give us for credit, as well as what we can negotiate with banks for operating facilities.

The business owner, the acquirer, will also review what is known as the ‘terminal value’ of cash flows. This is a more complex analysis in which the estimated cash flow is divided by the cost of capital – growth.

We’re in the home stretch – the last part of our analysis takes those future free cash flows and calculates the present value to see what they’re worth today.

In summary, whether Wall Street analysts are considering a multi-billion dollar merger, or if a business owner is looking to buy Bob’s seed supply, the above valuation techniques are ones that are always used by business acquirers and their advisors. The company, and its cash, is looked at from every angle to determine potential issues and necessary changes. A solid cash flow valuation makes or breaks the quality of an acquisition. The boss is ‘counting’ on that!

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