All Accounts In Operations In Staement Of Cash Flows 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 objectives is to assess ‘cash flow’. A business generates cash flow from three sources:

their operations/profits

Investment in business

Borrowing activity

When evaluating cash flow, business owners or their advisors go through 5 key areas of business cash flow. Those areas are as follows.

1. Reviewing the Income Statement

2. Analyzing the amount of cash to be spent on new equipment, plant etc

3. To check the total working capital position

4. Determining the total annual cash flow

5. Putting a value on those future cash flows

Where does acquisition start in this whole process? The income statement is carefully reviewed in terms of gross profit margin and better net income. After determining the final net income figure, the analyst ‘adds back’ the amount of depreciation taken by the company, as it was not an actual cash expense.

This gives us somewhat of a ‘magic number’ – aka ‘EBIT’. (earnings before interest and taxes)

The income statement is carefully analyzed – all the basics are reviewed: sales goals, physical costs, profitability and administrative costs. Since the business owner is investing in the future when he buys a firm, the above analysis is done for 3-5 years.

We then carefully look at all equipment (point 2 above) and determine useful life and replacement needs.

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 the cash flows. This is a more complicated analysis in which the estimated cash flow is divided by the cost of capital – growth.

We’re in the home phase—the final part of our analysis takes the future free cash flows and calculates the present value to see what they’re worth today.

In summary, whether a Wall Street analyst is considering a multi-billion dollar merger or a business owner is considering buying Bob’s Seed Supply, the above valuation techniques are the ones used by business acquirers and their advisors all the time. A company and its finances are looked at from every angle to determine potential problems and necessary changes. A solid cash flow valuation will make or break the quality of the acquisition. The owner ‘counts’ on it!

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