Before you can apply business valuation methods, you should determine the level of cash flows generated by the company. The question here is what cash flow?
For the purposes of business appraisal, the net cash flow is the typical choice. Here is its definition:
- Net income, after tax
- Plus depreciation and amortization
- Plus tax affected interest expense
- Minus capital expenditures
- Minus increases in working capital
Note that the net cash flow represents the cash that is seen by the shareholders and long-term interest bearing debt holders of the firm. In other words, it is the earnings that defines the value of all equity and debt interests in the company.
A couple of comments are in order here. First, net cash flow is an after tax concept. The reason we start with the after tax income is to focus on the earnings regardless of the company’s capital structure, i.e. what levels of equity and debt capital it uses.
To do so, the net cash flow is adjusted for the tax effect, as you can see in the above list.
Secondly, adjustments done for purely accounting purposes need to be added back. The typical ones are the paper expenses such as depreciation and amortization.
Finally, the funds needed to keep the company going need to be factored out. This includes both the long term capital expenditures and the working capital requirements. These funds cannot be taken out of the business and distributed to owners or lenders. The money is needed to buy new equipment, inventory, and other valuable assets the business needs to operate.
Net cash flow represents the level of business earnings most relevant to business appraisal. It shows the cash flow the owners can direct at their discretion toward business expansion or distribution to the shareholders. The effect of capital structure is removed since the owners can decide what levels of equity or debt they want to use in their business.