Financing Activities On A Statement Of Cash Flows Relate To Cash Flow and Business Valuation

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Cash Flow and Business Valuation

When business owners and their financial advisors review a company for acquisition, one of their main objectives is to assess ‘cash flow’. The business generates cash flows from three sources:

Their business/profit

Investments in business

Lending activities

When estimating cash flows, the business owner or his advisor actually goes through 5 key areas of business cash. These areas are as follows:

1. Overview of the profit and loss account

2. Analysis of the money that needs to be spent on new equipment, plant, etc

3. Checking the total balance of working capital

4. Determination of total annual cash flows

5. Evaluating future cash flows

Where does the acquirer start in this whole process? The profit and loss account is carefully reviewed with respect to gross profit margins and fine net profit. After determining that final net income figure, the analyst ‘adds up’ the amount of depreciation the business took, as it was not a true cash outlay.

This leaves us with something of a ‘magic number’ – the so-called. ‘EBIT’. (Earnings before interest and taxes)

The profit and loss account is carefully analyzed – all the basics are considered: sales targets, material costs, profit and administrative costs. Since the business owner is investing in the future when buying a business, generally the above analysis is done for 3-5 years.

Then we carefully inspect all the equipment (point 2 above) and determine the service life and replacement needs.

Point 3 brings us to the analysis of working capital. As sales increase, we need to have more inventory and receivables, balance what our suppliers will give us on credit, as well as what we can arrange with the bank for operating facilities

The business owner, the acquirer will also review what is known as the ‘terminal value’ of the cash flow. This is a more complicated analysis that involves projected cash flows divided by the cost of capital – growth.

We’re in the early stages – the final part of our analysis is taking those future free cash flows and doing a present value calculation to see what they’re worth today.

In short, whether Wall Street analysts are considering a multi-billion dollar merger or a company owner is looking to buy Bob’s Seed Supply, the above valuation techniques are always used by acquirers and their advisors. The company and its cash are looked at from all angles to identify possible problems and necessary changes. A solid cash flow estimate will make or break the quality of the acquisition. That’s what the owner of the ‘account’ is!

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