On a hot summer day when I was a child, I opened a lemonade stand in front of my parent’s house. Before I knew it, I had sold my entire inventory of lemonade. My sales mixture consisted of a small portion of cash paying customers driving by, however, a large portion was “credit” sales to my neighborhood friends who didn’t have cash on hand.
In no time at all, I found myself needing cash to purchase lemonade powder to make more lemonade. My income statement showed significant profit, but because of inadequate collection practices I was never able to get my friends to pay for the lemonade they drank. As a result, my statement of cash flow showed the reason for the demise of my business. I was never able to convert the sales I made into cash to fund the purchase of additional lemonade powder. My parents were also unwilling to make an additional capital investment in my business to purchase more powder because they were concerned I would continue selling on “credit”. The business ultimately failed because of a cash shortage.
A good valuation analyst knows that even the most profitable businesses can fail. Below are reasons a profitable business can fail, all of which pertain to cash flow concerns:
1. Longer credit terms and shorter payment terms.
2. Ineffective collection practices.
3. Reliance on a select few customers.
4. Undefined and unplanned capital asset spending.
It is important to understand profitable businesses fail for reasons other than cash flow issues, however, it’s vital to understand that a consistent cash stream is necessary for a sustainable business.
How is Cash Flow Important in Valuation?
Business Valuations rely on the use of three main approaches to determining the subject entity value:
• Asset Approach
• Income Approach
• Market Approach
The Asset Approach, also known as the cost approach, involves applying methods of determining a company’s value based on the market value of the underlying assets. The Asset Approach is often used to value realty holding companies and companies that operate at a loss or lack significant profitability.
The Market Approach involves valuation methods that use transactional data of guideline company’s sales to help determine a company’s value. It is based on the idea “guideline” companies sold in arms-length transactions represent a good proxy for the specific company being sold.
The Income Approach calls for the valuator to select a benefit stream to apply a selected multiple to in arriving at the entity value. In general, the two “benefit streams” considered are net income and free cash flow . This approach is based on the fundamental principle that the value of the business is equal to the present worth of the future benefits of ownership.
Going back to the example of my lemonade stand above, assume I was valuing the lemonade business and selected net income to apply the multiple in arriving at the total value of the business. In doing so, I would significantly over value the entity because, as we showed above, even though my business was highly profitable, it failed due to cash flow issues. When valuing the lemonade business, applying the multiple to the free cash flow seems like a more accurate calculation of the businesses value.
Business Valuation is not an exact science but solely relies on the professional’s expertise and experience. This is where our Business Valuation professionals at TD&T CPAs and Advisors, P.C. can help. Our group of full-time Business Valuation professionals have formal training, education, and years of experience which enable us to identify and apply the appropriate valuation techniques based on the different types of businesses we value. Remember, Business Valuation isn’t cookie cutter, so your valuation analyst’s skills and experience shouldn’t be either.
As a full-service CPA firm, not only can we serve the needs relating the Business Valuation, Forensic Accounting, and Litigation support, but also business consulting and tax related issues. Feel free to reach out with any questions you may have!