Interest and business value

What would the value of my business be if I had no debt?

The question arose in a recent valuation exercise we did for a small manufacturing concern. The owner was agonising over the fact that he had put up everything he could as collateral for a loan, including the domestic kitchen sink, the “domestic” cleaner herself and other domestic incidentals like his wife and loins linked fruit. The loan was to get his factory working with more up to date equipment.

His subsequent frustration was in the fact that not one of his cash flow forecast months had been accurate. When are they ever? That is another story, but in essence I have never seen an accurate forecast after the fact. That makes the concept of discounted cash flow valuation models tenuous at best.

He envisaged installing the new box of tricks, which would seriously raise production efficiencies, and cause his sales numbers to soar. Not quite the way things worked out: 1) The commissioning of the machinery took longer than expected. 2) The workflow transition had more problems than he could have expected. 3) Customers who were used to a quick turnaround looked elsewhere when they had delays, and found better prices. Years of comfort ordering went out the window.

So when he eventually got going again, albeit it with better and more efficient equipment, he had some work to do to get sales up to speed. “Been there, done that. It is like when…”, I hear half my readers muttering.

So where does he sit now? He has a better mouse trap, and things are looking up. Sales growth is not quite what he expected, but as long as his wife does not find out that she has been pledged to the money lender… Wait… I jest.

His business has a very big interest account every month. The quantum amount is exactly what he was expecting, but the proportion of interest to the turnover is way higher than he had planned for, and frankly he is nervous.

The impact on business value

There is a calculation we do around the mix of equity (value of the shares) versus the amount of debt a business should take on in order to maximise value of the enterprise. It is one of those cross roads questions.

Our hero missed the cross road, and drove straight over the chevron. He’s a tough German off roader, so he’ll thunder through the veld until he gets back onto the right road, with a bit of GPS guidance.

The value of the business has not been affected by the higher interest bill because small and medium size business valuations and sales take that into account. The effect is hardly worth a mention, even though his profits have gone down by the amount of interest. As I say, it is hardly worth a mention; but that is provided the business survives.

His value HAS been affected by the loss of sales, which has had a further direct impacted on his bottom line. So the amount of bottom line decline as a result of sales loss does affect his value (in the short term, provided he survives), even if the loss to extra interest payments does not.

In the near future, as his sales first regularise, his higher capacity will in turn allow for the sales to grow, and because he now has a bigger chunk of gross profit to play with, his bottom line will increase significantly. His fixed overhead is unlikely to grow at the same rate as the sales growth because of the efficiencies his new equipment brings to the party.

He will easily be able to win his lost customers back with competitive pricing and his radiant personality. All things being taken into account somewhat after the fact, his business will be worth much more.

What will happen if (more likely “when”) interest rates rise? That becomes a little more complicated.


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