Should You Value A Business Solely On Cash Flow?

Determining the value of a business becomes critical when you are buying or selling a company. The challenge lies in the fact that the price tag of th

  • Should You Value A Business Solely On Cash Flow?
    Antoine Fraser' Image Antoine Fraser

    Should You Value A Business Solely On Cash Flow?

    Determining the value of a business becomes critical when you are buying or selling a company. The challenge lies in the fact that the price tag of the venture is not usually acceptable to the prospective buyers. Thus both the parties need to agree on a selling price which is considered to be a good match for the perceived value of the business. There are dozens of ways of finding the selling price of an entity ranging from marketplace trends to asset evaluation and bottom-line projections.

    However, cash flow is commonly used as a metric for calculation of the worth of a company by both sellers and buyers. This methodology is more suitable for companies which have been in business for a long time and enjoy a steady income which can be easily predicted. It also plays a significant role in determining the future profitability and stability of the business model. Thus if you are planning to purchase a business for sale in Canada, you must read this article further to know whether it should be the only criterion for business valuation or not.

    What Is Cash Flow?

    Purchasing an established business needs as much planning as setting it up from scratch. The data that needs to be examined and the volume of numbers that need to be crunched can give anyone a splitting headache. Thus it is a wise decision to hire accountants to help you with the evaluation. You can find experienced and qualified accountants quickly by visiting the Canadian Institute of Chartered Business Valuators website. The discounted cash flow technique is a popular and reliable method used by traders for business evaluation. However, one must understand the nitty-gritty of this quantitative method before going ahead with it.

    Typically, the cash flow of a company is represented by the incoming and outgoing cash. It comprises the amount of money coming in from payments and the amount going out due to expenditures. Besides independent businesses, many people are interested in buying franchises to reach their entrepreneurial goals. Usually, the valuation of these units follows the terms defined in the Franchise Agreement. However, other assessment methods can be utilised to know their worth as well.

    Why Is Cash Flow Important?

    Cash flow is an important criterion for judging the health of a business because it assists in predicting the value and timing of inflows and outflows. When the owner has a definite amount of funds on-hand, he can effectively use them to make payments and reinvest the money back into the business for more profits. The only problem with maintaining cash flow is that the business may be making revenue by acquiring more projects, but the payments from the clients may get disbursed after months of starting their work.

    It leaves the company with a deficit as they need to pay the employees and spend on other expenditures during the waiting period. Thus companies need to make sure that money keeps flowing in through the doors and they have ample work on their plate. Thus depending only on revenue to calculate the value of a business is not the right way to arrive at the selling price. The income statement is a legible valuation tool.

    The Discounted Cash Flow Valuation Method

    All enterprises follow EBITDA which stands for Earnings before Interest, Taxes, Depreciation and Amortisation. It aims at calculating the total income of the company before deducting interest, taxes, depreciation in the value of the tangible assets and reduction in the value of intangible assets. It assists in measuring the profitability of the business and its financial performance when selling a business. Future projections of cash flow are calculated for a defined forecast period and then discounted at an annual rate to arrive at the current value. If the discounted cash flow is higher than the present value, then it is considered as a high-yielding investment.

    Should the Cash Flow Method Be Solely Used For Business Valuation?

    Though the choice lies with the buyer and the seller, in the recent years discounted cash flow method has emerged as a viable metric for business valuation. The reason behind this is that many businesses are using inflated revenue projections in their books and there are rising apprehensions over the credibility of the P/E ratios. The cash flow metric offers a more transparent approach but involves a lot of hard work.

    The end result of the effort is fruitful as it provides insights into the key drivers of the share value and it is not affected by bad bookkeeping or aggressive accounting. However, this should not be the only technique used to evaluate a business as the company may not be able to meet the financial expectations or the interest rates may vary which means that the estimates would go for a toss. There are other business valuation methods which must be utilised to come up with a satisfactory and acceptable figure.

    Endnote

    Thus if you are planning to buy a business for sale in Canada, you must utilise all the pricing techniques to know the actual worth of a company. Additionally, you can hire an accountant to help you with the evaluation process and avoid spending more than required.

  • Author Info Antoine Fraser

    Antoine Fraser (born in 1981) is a writer and guest lecturer of Masters in Business Administration in different Universities of Ottawa. He was born and raised in Belleville, Ontario and moved to  Ottawa, Ontario, to attend the most prestigious Carleton University. He also holds a PhD degree from School of Management, Branford. The interest of his research has been in the field of small business programming, public policy and small firm growth. He has also published in trade publications with insight from globalisation and finance. His affiliation with Business2Sell is a matter of pride for us.