One of the most important choices you can make when valuing a company is the proper selection of earnings basis. The idea is to capture the true earning power of the company. In virtually all professionally done business appraisals the earnings basis is some measure of cash flow.
The typical choice is the net cash flow. The reason net cash flow is so popular is that it represents the part of overall business earnings that can be taken out by the owners and debt holders without impairing the continued operations.
One of the key components of net cash flow is changes in working capital. Increase in working capital indicates that the management is investing resources in the short term. This exerts a drain on available cash flow from the operating, financing and other investment activities.
Conversely, a negative change in working capital over a period of time shows that the business has relied upon short term borrowing to finance its operations. This generally results in a cash flow increase.
When changes in working capital are significant, you can see net cash flow figures that may be surprising. Reviewing anomalous cash flow fluctuations is especially important when generating an earnings forecast for such valuation methods as the discounted cash flow.
A single period of above or below the norm earnings in your forecast may be enough to skew your business valuation results, especially if it occurs early in the projection. Some questions you may ponder are:
- Does the working capital investment lead to increased sales and profitability down the road?
- Is short term vendor borrowing a wise strategy to finance operations?
- Does the company risk profile change as a result?
- How do these management decisions affect business value?
Business valuation based on cash flow
See how to use a cash flow forecast and business risk assessment in your business valuation.