Valuing a Business on Cash Flow: Everything You Need to Know
Valuing a business on cash flow means assessing the health of the company based on the cut and dry information from the balance sheet and looking specifically at the present-day activities of the business.3 min read
Valuing a business on cash flow means assessing the health of the company based on the cut and dry information from the balance sheet and looking specifically at the present-day activities of the business. This is also known as an asset-based or book value assessment and is one of the ways in which the health of a company may be judged. The other two are:
- Income approach
- Market approach
While this is certainly an easy and factual way in which to assess a business, it does not account for future growth and income generation. As such, if your business is one that is ongoing, with anticipated additional income, this asset-based methodology may not be the most advantageous way to look at the financial health of your company.
This book value assessment is most commonly used in evaluating a business that has failed.
Income Based Approaches
When it comes to utilizing the income-based methodology for evaluating the health of a company, there are two additional approaches, and they are used to best determine future income generation:
- Capitalization cash flow method, which is used when a company is expected to have a stable future in terms of growth. Typically, this approach assumes one consistent stream of cash flow that is assumed to grow steadily, long-term. Additionally, this method is most frequently utilized when looking at the health of an established company.
- Discounted cash flow method, which provides more flexibility than the aforementioned method and allows for greater ebbs and flows in income stability, such as changes in the stock market, new debts, paying off debts, etc. Given the variables this methodology takes into account, the discounted cash flow method is commonly applied to companies that may still be in their active growth period and taking on new debt while still paying off past debts.
Regardless, if you are in a position of selling your business, or otherwise needing to evaluate the overall financial health, there are certain documents that you will want to ensure you readily have. Among them are:
- At least three years worth of profit and loss statements, including the balance sheets
- At least the most recent three years tax returns for the business
- A copy of your lease if you rent the property where your business is located
- A list of all major pieces of furniture and equipment which may add to the overall value of the company
More on Discounted Cash Flow
Business owners, particularly small business owners, should always be on top of valuing their business, as it is crucial for obtaining additional funding through investors such as financial institutions, new partners, and angel investors. Having this information at the ready can also make everything much easier should you be looking to sell your company.
Using the income statement of the company is the easiest starting point in determining the value of a company, and typically income is reported before interest, taxes, depreciation, and amortization. This is commonly referred to as EBITDA, and it must be considered by a business owner when utilizing the discounted cash flow method.
Essentially, the discounted cash flow method is going to take into account the current status of our business, while also factoring in potential future growth, in determining the overall picture of the company. By using this method in the sale of a company, it does not only value the company based on the present day but using projections determines when the continued growth of the company would level-off.
Forecast Period with the Discounted Cash Flow
Generally speaking, a business owner wants to project their company’s cash flow up to three to five years ahead. However, if you are to be selling your business, you will need to consider the future income that may be generated as a result of said sale, depending upon what the new owners depend on doing with your company.
While there are many financial factors that contribute to the health of a company, the Seller’s Discretionary Earnings, or SDE, are not considered to be part of normal business operations. The SDE is the income before taxes and generally EBITDA. For example, as a small business owner will pay himself a salary that is at or above market value, that would be considered SDE.
If you are looking to sell your small business, it is worth noting that, taking into account all factors, many sell for 1.5-3.5 times the SDE.
If you need help with valuing a business on cash flow, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.