Does your business have a positive or negative cash flow?
Throughout this series, we’ve been discussing the importance of good money management, how it’s linked to business growth and some basic skills to help tighten up cash flow.
Be sure to catch up on our first article, How Cash Flow Can Cripple Your Business. Could You Be at Risk?
In this article, we delve a little deeper. By looking past your business growth strategy, we focus on another area which is deeply impacted by the success, or demise, of your cash flow: Your business valuation.
Should you choose to sell your business, your finances, cash flow and working capital all contribute to the price you will receive. Even if that day is far down the track, it’s never too early to start developing a well-thought out exit strategy to protect your investment and your future.
We work with SMEs to help achieve successful exits by assessing their business against the core drivers of value to determine so you can sell your business at the highest possible valuation.
Selling a business? How cash flow can impact business valuation
To understand how cash flow impacts your company’s value, start by looking at the situation through the eyes of your prospective buyer.
Do you pay your bills on time? Are you constantly chasing up late payments from your customers? If you’re consistently dipping into your own funds to cover bills, wages and expenses, then your business has a cash gap. The existence of a cash gap means you need to inject more money into the business for you to be able to stay solvent, and meet your liabilities as, and when, they fall due.
Every business needs to maintain day-to-day cash flow or else it will end up as one of the 30% of businesses which fail due to poor money management. This is a dynamic balancing act between your current assets and liabilities. If you lean too far to one side it will raise red flags for a potential investor. But if your business is not cash hungry and you manage your finances well, you could be in for a bigger payout.
This is because there are two figures a buyer takes into consideration when determining the value of your company.
One is the lump sum needed to buy the business, which is a direct payment to you. The other is the amount required to finance any existing working capital; essentially what’s needed to keep the business afloat after you hand over the keys.
The catch is, this money comes from the same wallet, and if your buyer has to inject more money into the working capital, then there’s less allocated towards the price of the business, which reduces the amount you are paid.
Working Capital and Valuation: An Inverse Relationship
The less working capital your business requires, the more it will be worth...and vice versa.
Founder, The Value Builder System.
An acquirer will assess your company’s worth by looking at a range of financial ratios. One way of determining reviewing liquidity and how well you manage your cash is by looking at the Quick Ratio (or Acid Test Ratio).
This is calculated by dividing your current assets by your current liabilities. Ideally you should have a number greater than 1, preferably around 1.5 or higher. A number less than 1 could be a sign of liquidity problems and that the business would need an injection of working capital. Both of which would be a red flag for a buyer.
One thing to always remember is that any buyer will want a return on investment. If your business generates a $500,000 profit, and the buyer wants a 25% return on their investment, then they would likely be willing to invest up to $2,000,000 for your company.
But before you start spending 2 million dollars, it’s crucial to keep in mind this critical point. A buyer isn’t just paying you for the business, they also need to cut a cheque for the working capital, which is usually included in the total investment they are willing to make.
Therefore, if your business requires $300,000 in working capital, then this amount is factored into the $2,000,000 the buyer is willing to pay, leaving only $1,700,000 to pay you for your company.
Working Capital = $300,000
Consideration for the business = $1,700,000
Total investment = $2,000,000
Know your pressure points: Understanding your working capital
There are many different factors which can affect the level of working capital. Especially considering each industry has its own nuances, and often businesses experience seasonal fluctuations.
While seasonality can often be reasonably predictable throughout the year, it is mostly out of the control of a business owner. What remains crucially important throughout the process is creating a business strategy that targets the right products and/or services to the most profitable markets, and that also produce good cash flow. Some things to note:
If your business relies on holding a large inventory in order to meet your customer needs, this needs to be taken into consideration during your business valuation. Consider whether the ‘just-in-time’ methodology pioneered by Toyota or other lean inventory management techniques could improve this.
Production Lead Times
If you deal with products that have a short life span, your inventory will have a higher turnover rate, lessening your working capital, than if your products take longer to sell.
Payments and Invoicing
Consider negotiating longer payment terms with your suppliers and look at strategies to collect cash earlier. Don’t assume that suppliers and customers will never consider these options. Consider how to have this discussion and what other (less costly) compromises you may be willing to make. Sometimes offering a discount for early payment to your customers can cost you less than chasing invoices for extended periods.
While having your customers pay up front is ideal, many businesses will not be able to support that. Instead, there are several solutions to control your cash flow which we will go over in the next article.
But if you plan to sell your business, either in the immediate future or further down the track, you’ll want to get your house in order. It’s essential to incorporate a program to manage and optimise your working capital. Not just because it makes good operational sense, but it will also add to your business valuation.
If selling your business is on the cards. Here are some other articles that may be of value to you:
If you would like to know more about how Exit Advisory group helps business owners like you, feel free to get in touch:
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