This article originally appeared in the March 2014 issue of Smart Business Philadelphia magazine.
Companies are valued based on a formula that takes into account cash flow and the multiple that a buyer would be willing to pay. Increasing the business valuation of a company amounts to finding ways to affect those two factors.
“Certain businesses, like a developer investing in land, are valued based on how much their assets are worth. But 90 percent of companies are valued based on their cash flow. So you need to increase cash flow if you want to increase the value of the business,” says Mario O. Vicari, a director at Kreischer Miller.
Smart Business spoke with Vicari about how owners can make businesses more valuable.
What is the formula for determining the value of a company?
Essentially, the two components are how much cash flow the company produces and what multiple a buyer will pay. At a very basic level, a business with a cash flow of $100,000 that finds a buyer willing to pay a five multiple would be worth $500,000.
The multiple is based on the risks associated with the cash flow, which is principally concerned with how sustainable and predictable it is. If a company derives its income from having to bid and win contracts, that cash flow is difficult to predict. A business that has more repeatable revenue, like a building maintenance contract that reoccurs every year, would represent a lower risk and a higher multiple.
What are some steps to take to increase cash flow?
Consider ways to increase revenues, lower costs, or both. At the highest level, that involves looking at your sales plan and marketing programs. Where are the best opportunities for sales growth? Can you sell different things to your existing customers through line extensions or take market share by attracting new customers through a targeted marketing effort or geographic expansion? Pricing and margins are also a significant consideration because sales growth without appropriate margins will not create value in the business, since cash flow will not increase. On the cost side, some consideration should be given to your cost of sales and making sure that your direct costs are optimized and throughput is high. Overheads should also be looked at closely to ensure that costs are optimal to support the sales growth the company is targeting. Overheads can be tricky, since a reduction has a direct impact on the current year cash flow but too much cutting can affect the business’s ability to grow in the future.
It comes down to how you manage your income statement, and how you drive net income through some combination of growth and more efficient use of resources.
How can a business owner lessen risk and increase the multiple?
There are several things an outside party will look at when considering risk associated with a business’s cash flow. If your customer base or product line is not diversified, that’s a much riskier situation because the loss of one big customer or a product would significantly affect the cash flow. If that’s the case, you should consider how to diversify your customer list and product offerings to manage that risk. Supplier concentrations can also increase risk and, where possible, you should diversify your supply chain.
An often overlooked risk is the depth and breadth of the management team and whether you have a succession plan. A company might have good cash flow, but if too much responsibility revolves around the owner it’s not going to be worth as much because it’s not sustainable if the owner were not there. Good management systems and qualified staff can add a lot of value to a company because they increase the likelihood of the cash flow being sustainable. Lastly, there is one element that fits into both cash flow and risk categories — utilization of assets. If you can turn over assets like receivables and inventory in 60 days instead of 90, that means you need less money to finance those assets and your cash flow increases. Additionally, efficient utilization of fixed assets also is important because a company has more cash flow and is more valuable if its reinvestment rate in fixed assets is lower.
For most private companies, the business is the owner’s primary asset. We encourage business owners to look at the business as an investor would and think about these value drivers so they can ensure they are increasing the value of their biggest asset. ●
When you’re ready to discuss business valuation strategies, we’re delighted to be of service. Please reach out to us to get started.