When business owners and their financial advisors review a firm for acquisition purposes one of their main goals is the assessment of ‘cash flow ‘. Business generates cash flows from three sources:
Investments into the business
When cash flows are being assessed the business owner, or their advisor is really going through 5 key areas of the business cash. 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 situation
4. Determining the total annual cash flows
5. Putting a value on those future cash flows
Where does the acquirer begin in this entire process? A careful review is made of the income statement with respect to gross profit margins and fine net income. After determining that final net income number the analyst ‘ adds back ‘ the amount of deprecation the company took , as it was not a real cash outlay .
This leaves us with somewhat of the ‘magic number ‘- aka ‘EBIT ‘. (Earnings before interest and taxes)
Careful analysis is made of the income statement – all the basics are reviewed: sales goals, material costs, profits, and the administrative expenses. Since the business owner is making an investment in the future when he buys a firm generally the above analysis is done for 3-5 years out.
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 grow we need to carry more inventory and receivables , balance by what our suppliers will give us for credit , as well as what we can negotiate with the bank for operating facilities
The business owner, the acquirer also will review what is known as the ‘terminal value’ of the cash flow. This is a more complicated analysis involving projected cash flows divided by the cost of capital – growth.
We are in the home stretch – the final part of our analysis takes those future free cash flows and does a present value calculation to see what they are worth today.
In summary, whether Wall Street analysts are contemplating a multi billion dollar merger, or if a business owner is looking to buy Bob’s Seed Supply the above valuation techniques are those that are always used by business acquirers and their advisors. The company, and its cash, is looked at from every angle in order to determine possible issues and changes required. A solid cash flow valuation will make or break the quality of the acquisition. The owner is ‘counting’ on that!