Recent business valuations highlighted the importance of high EBITDA, low working capital and good cash flow management processes can release cash available to the business owner and increase business valuations.
In most cases business valuers use an adjusted EBITDA as a proxy for cash flow when calculating the value of a business. With the right adjustments and ensuring a couple of assumptions are reasonably correct this provides a reasonable assessment of business value.
However the correct term to use in any calculation of value is "free cash flow". In times of low revenue growth (such as many businesses are experiencing right now), it is critical to focus on cash flow and not just EBITDA.
Tougher Lending Conditions Are Already Here
We have seen a number of clients experience increased bank scrutiny on existing loans, and in one case the finance was cancelled as the bank felt the risk profile of the business had increased too much, despite a perfect payment record. Paul Carpenter of STAC Capital eloquently explained how this may increase in frequency in one of his recent blog posts Tougher funding for business ahead.
Basically they explain that with Commissioner Haynes recommending changes to the definition of small business (to include having loan amounts less than $5m), the banks are likely to tighten lending because the definition of “small business” impacts on the ability of a bank to include ongoing covenants as part of their loan contracts.
As a result of this, the banks will increase scrutiny on existing lending facilities and tighten limits on new loan approvals or increase interest rates. In these circumstances it is important to get advice from experienced finance professionals, such as STAC Capital on how to structure debt finance (and other sources of capital)
Regardless of what the banks do, we can be assured that finance over the next 12 - 18 months is likely to become harder to get.
How does this impact EBITDA and cash flow?
Now back to business valuations, EBITDA and free cash flow.
EBITDA is a reasonable assessment of free cash flow when:
Earnings (EBITDA) growth is flat or will follow a steady, linear increase.
Where the risk profile of the business remains constant over the short - medium term period.
Relatively simple adjustments can be made for any ongoing asset investment required to maintain current operations.
Adjustments (add backs) can be made to reflect any accounting adjustments made in the past.
Non-cash working capital remains constant over the projection period.
It is the last assumption that often catches out the in-experienced valuer - and in a period of low revenue growth when a business owner needs to pay close attention to working capital (and reduce it), it can often mean the difference between a good and bad business valuation.
One of the key things we like to see is not just a commercial level of EBITDA, but also a positive EBITDA adjusted for the change in non-cash working capital(CNCW) = EBITDA - CNCW
Where CNCW = (Increase in Accounts Payable/Creditors) - (Increase in Accounts Receivable/Debtors) - (Increase in Inventory)
We often find that when revenue has increased (or decreased) dramatically from one year to the next (or one month to the next) there will be a significant change in non-cash working capital.
This will reduce the adjusted EBITDA and in some cases can make the resulting cash flow negative. If that is a continuing trend then the business is in trouble and the valuation is going to be severely reduced.
How does this affect business valuations?
As you may have gathered, the lower the free cash flow the lower the valuation. So if you have an increasing NCWC requirement, this will reduce the adjusted EBITDA and therefore reduce the business valuation.
However there is another factor where this can also affect business valuations - the EBITDA multiple. If the business is seen not to have effective cash management procedures and business reporting processes then this represents a higher level of business management risk. If considered to be of significant impact on the business then the multiple is likely to be reduced to represent the higher level of risk. This will also reduce the business valuation.
Some key cash flow management practices I can recommend includes:
Track on a monthly basis the change in non-cash working capital - contact us if you would like to discuss how to do this
Project adjusted EBITDA (including the effects of NCWC) for the next year and even the next rolling 3 month period (we often do this as part of our business valuation process).
Don't just reconcile the bank transactions on a weekly basis, make sure the right accounting adjustments are made on at least a monthly basis so you can accurately predict what your cash balance will do in the near term.
Make sure these adjustments include owners wages - even if the owners wages are taken as drawings or dividends. They still represent a drain on cash reserves and must be taken into account.
We know that cash management is often boring for the business owner, and tedious. It can also generate a lot of stress and tension and so many business owners tend to avoid it. However, I have also seen many businesses find cash after implementing better cash flow management processes. Face the mountain and climb it one step at a time - it will dramatically increase your business valuation.