There is a simple calculation we do when conducting valuations on businesses; similar to one which is applied by many valuers around the world for large corporations. It is simply a comparison between the operational cash flow and the net profit of the business. Only ours is different!
The thinking goes something like this: It is all very well that a business is selling stuff, and invoicing it; but what if those invoices are being paid very late? We all understand that situation: You did some work at the beginning of the month, invoiced it, and mailed the invoice. You happily went about your junk for the rest of the month expecting to be paid at the end of that month. “Oh no, we’ll pay you at the end of this month. We thought it was 30 days from statement”. So there you find yourself with a nice profit, but no cash flow.
With time, and a fair margin, you are able to drag your business into a cash reserve position where you can carry yourself. On very tight margins, it is still very difficult if your customers pay you late. A strong growth spurt, although profitable, can kill an underfinanced business. Result: No value.
With good margins, strong growth can be exciting, provided these new or bigger customers pay when expected. Paying on time comes from good debtor management. The business has value.
Where a business has strong margins, but poor debtor management, things could go either way, and that is where the comparison between net profit and operating cash flow is most telling.
The metric works well for large corporations, particularly those listed on the JSE, and subject to the rules of the stock exchange. There is a size above which this becomes imperative for private businesses too. But when advising small businesses on their value, something far more important comes into play.
Let me start here: When one, or only a few blokes are involved in a business at a time that the project requires cash, they do what is required:
- Bond a home
- Borrow from family and friends
- Sell a car
- Delay payments of personal bills
- Give up the gym membership
- Take kids out of private schools
- Eat pap and gravy for a few weeks
- Give up DSTV {OK, now you’re getting silly – Ed}
Those are the costs of risk that the small guys absorb in order to keep their dreams alive, pay staff members their salaries and generally keep the machinery running. They don’t always have the benefit of calling on wealthy shareholders for more funds, and few small business owners have the luxury of great reserves to draw on.
Until the boat comes in, that is. It’s at this point that things begin to happen – like employees demanding a share of the business. Employee share schemes are not a great idea, and those demands normally happen once the start-up risk is a thing of the past. (That’s what makes them employees).
Along with that comes an ability for certain personal expenses to somehow find themselves in the list of business expenses, and the business owner is able to pay himself a salary commensurate, not necessarily with experience and ability, but more likely with the amount of pain the he endured in getting to this profitable point.
So The result for a public company is that it prefers to keep this bottom line as high as possible to allow its directors to keep their jobs, because as you know earnings drive the share price and the benefits flowing from their stock options.
The result for the small business owner is that he has to balance tax planning with reserves and his own income (and tax attracted). Then when he one day sells his business, he has to find a way to demonstrate real value to the prospective buyer.
So the small or private business owner has another metric in mind, and it usually has very little to do with what is on the bottom line of his income statement. It is the benefit he is drawing from his business.
The public company will compare operating cash flow with net income. The private business owner will compare operating cash flow and his own benefit from the operation, with the net profit. And that is where an eventual buyer of a private business will also have his eyes. That is where the value is in the business. And that is why small businesses cannot be valued on the same basis as those much bigger entities which adorn the text books of our accountants.