You may have heard this said about running a business – cash is king. You will find that cash is also important in business valuation, especially when the calculations involve the income-based methods.
The idea behind these valuation methods is to determine the business value based on its earnings generation capacity given a level of risk. The central question is: what type of income can the owners expect to get out of the business?
To make the valuations work, you would need to make a selection of the income, usually some form of cash flow. The cash available to the business owners is what is left over after the funds required to run the company have been accounted for. Business appraisers use a number of well known cash flow definitions in their analysis, including:
For owner-operator managed small businesses, the SDE is an excellent choice. It represents the level of available cash flow the hypothetical business buyer can expect upon a business purchase. Net cash flow is often used to value larger companies and demonstrates the returns business owners can remove out of the business without negatively affecting the operations.
If you take a closer look at the actual elements that make up the SDE and NCF cash flow measures, you will see how the important requirements have been accounted for. For example, business owners cannot expect to dip into the bank for distributions or salaries until after the capital requirements have been met. New equipment must be bought or existing machines properly maintained so that the company can keep producing the income. The same goes for the short-term investment in working capital such as the need to increase inventory before a seasonal increase in product demand.
Unusual or one-time expenses can skew the available cash flow. In such cases, you may wish to adjust the cash flow calculation to remove these items. For example, moving expenses are not likely to be incurred regularly, so for the purposes of business valuation you can factor out these charges.
On the other hand, if the current owners count rental income from unrelated real estate as part of their income, the available cash flow needs to be adjusted downward since the income is not due to business operations.