Equipment and inventory are tangible assets required to generate sales and earnings. They are certainly critical to many business operations. But when it comes to determining a business’ value, the hard truth about hard assets is that they make no difference.
What really matters is the cash flow generated from these and other operating assets. Yet, so many business owners believe there is some mysterious process that will allow them to add the value of these assets to their grand total when it comes time to sell.
The danger with setting an inflated asking price is that your business may be passed over by good, qualified buyers. The longer it its on the shelf, the less appealing it becomes. You also open yourself up to experienced buyers leveraging an inflated price to get the upper hand during the negotiating process.
Why the “add on” philosophy doesn’t make sense
Consider the following examples of two businesses.
The first is a trucking company with $500,000 in trucks and dispatch equipment, all of which it needed to run the business. The second is a roofing company with a small number of employees and only $45,000 in inventory and equipment.
The trucking company generates $200,000 in cash flow, whereas the roofing business earns $800,000. Even though the trucking company has more hard assets, most buyers would find the roofing business much more attractive because of its far stronger cash flow.
Proponents of the “add-on” philosophy would argue that if the above two businesses each had a cash flow of $300,000, the trucking company would justify a higher price. But this doesn’t make good business sense. Ask yourself, would you pay more for the same level of earnings?
Knowledgeable buyers are interested in cash flow and cash flow alone. They will insist that the assets needed to generate that cash flow are included in the sale price.
The level of inventory will have virtually no impact on value. Business owners often try to rationalize this “add-on” logic because their inventory fluctuates throughout the year. Unfortunately, this method increases the risk for any given business. The inventory at closing may not be enough to support the cash flow, thus requiring the buyer to invest within to support the business.
At best, adding inventory to the price of a business increases the risk that the buyer won’t get their expected rate of return on their investment. At worst, this method could lead to business failure because the firm will be undercapitalized and unable to acquire additional funds to buy the necessary inventory.
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The reality for many businesses is that there aren’t significant variations in the amount of inventory that they carry throughout the year. Those businesses that do tend to see those fluctuations only during a few months of the year, such as holiday seasons. It’s not that difficult to determine the inventory that should be included in the price to support the annual gross sales and cash flow.
Exceptions to the rule
There are some situations in which assets are considered in valuing the business. Equipment, inventory and other assets are considered when a company is being sold under less-than-ideal conditions, such as when it has no profits or cash flow. In those cases, assets would be used to determine the value of the business. Problems then arise in establishing the worth of those items. Typically, buyers aren’t interested in these businesses because the seller already has proven that the company hasn’t made a profit.
But for the most part, cash flow is crucial to building value.
Three ways to increase cash flow
1. Stay active and focused: Countless owners have watched profitability slip away as they became more interested in the next stage of their life. Get active in the development of key employees, because they will be the catalyst for driving sales, operational efficiencies and customer satisfaction. Plus, stay focused on limiting your role in the day-to-day operations of your business. The less customers need you personally, the better the chance for growth.
2. Build a bigger mousetrap: Size matters. Find ways to add sales volume. By opening new geographic markets, you may be able to take advantage of organizational synergies and build a larger volume of customers and sales. Alternatively, look to introduce new products or services you may sell to existing customers and build some depth with folks with whom you already have a relationship. Finally, similar to many businesses, you may find building market share by adding new customers as the most logical step for sales growth.
3. Operate on the cheap: There is little glory in finding more cost-efficient ways of doing things, but these often deliver the quickest road to prosperity. You should regularly review and challenge your suppliers to ensure you’re getting competitive pricing in areas such as rent, insurance, utilities, wholesale goods and office supplies. Remember: a dollar saved on operating expenses goes directly to cash flow.
Buyers are looking for businesses with positive cash flow. By focusing your efforts to build value through improved cash flow, you will improve the day-to-day operation of your business, enjoy a higher selling price and improve the likelihood of a successful transaction.