Pocket change

guest commentary by David Potts

I promised you in my last commentary that I would move from the clinical to the practical in discussing how to increase the value of your business. I will keep my promise. However, I need to briefly review the clinical.

The value of a business equals the total of the expected future benefits derived from ownership. Of course that’s the value of anything from an iPod to 100 shares of Google. It just depends on how you define future benefits. Future benefits when talking about the value of a business are usually defined as expected net cash flows.

One of the most common valuation methods used to convert the expected future cash flows of a business into a dollar value is the discounted cash flow (DCF) method. The DCF method sums the “discounted” expected future cash flows of the business to arrive at the value. Rather than try to explain in detail how the discounted cash flow method works, let me refer you to Wikipedia or your old college Finance course book for those details. However I want to discuss the inputs to the DCF formula that affect a company’s value: net cash flow, the cost of capital, and, implicitly — growth of net cash flows.

Let’s get practical.

I’m sure everybody understands what I mean by net cash flow. I mean money in the bank. But not just any old money. It’s the money that is available to be paid out to the owners without jeopardizing the future operations of the business. So if you want to increase the value of your business, you start by increasing net cash flow.

The first thing you should ask yourself is, "Am I operating my business as efficiently as I can?"

The good thing about a recession like we just had is that it can put such financial pressure on you that you have to analyze how efficient you are operating your business — that is if you want to stay in business. In order to operate your business more efficiently you may have to cut bloated staff, eliminate wasteful spending, and better maintain your equipment. You may have to operate your business without carrying the extra inventory that “might” be needed someday but seldom results in sales. Running your business efficiently could also mean eliminating poorly performing assets such as certain product lines or services. In order to understand your options and make good decisions to increase operational efficiency, just remember a good financial reporting system is required.

Are you managing for growth? People will pay more for a company that is expected to grow than for a company that just maintains the status quo. The higher the growth rate the more they will pay.

One of the best examples of people paying more for a company with exceptional growth is Wal-Mart. Twenty and 30 years ago before Wal-Mart had taken over the world people were paying 40 and 50 times the company’s current earnings for a share of stock. Although your company may not take over the world it will sell for a higher price if its current history demonstrates its ability to grow. One caveat: I’ve seen small businesses have to file bankruptcy because their company grew faster than their ability to manage. Rapid growth must be expertly managed to survive its many growing pains.

The greater the perceived risk is in owning a particular business, the less people are willing to pay to buy it. In the DCF model, risk is reflected in the cost of capital. The cost of capital is the expected rate of return required to attract the funds to a particular investment. The greater the perceived risk the larger return on the investment a buyer requires. A greater risk requires a greater reward. But what exactly is meant by risk? Risk is the degree of certainty or uncertainty as to the realization of expected returns on the investment. Generally, perceived risk for a business will be higher the more volatile its earnings. Buyers perceive more risk in smaller companies. Perceived risk may also be influenced by the industry in which the company operates.

If you want your business to be a valuable asset that increases your wealth, or that you might one day sell to reap the material benefits of all your hard work, it must be managed. It must be managed to operate efficiently and to grow. Ultimately you end up with more cash in your pocket. Isn’t that why you began your business anyway?

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]