Cash flow measures the cash coming in and going out of your business whereas income is an accounting interpretation of your company’s net earnings or loss over a period of time. For example, if you charge $10,000 upfront for a service that takes three months to deliver, you would recognize $3,333 of revenue per month on your profit and loss statement for each of the three months it takes you to perform the work. But since you charged upfront, you receive all $10,000 in cash on the day your customer decides to buy.
This positive cash flow cycle improves the value of your company because when it comes time to sell your business, the buyer will have to write two cheques: one to you, the owner, and a second to your company to fund its working capital (i.e. the cash your company needs to fund its immediate obligations like payroll, rent, etc.). Both cheques, however, are drawn from the same bank account. Therefore, the less the acquirer has to inject into your business to fund its working capital, the more money it has to pay you, the seller.
The inverse is also true. If your company is a cash drain, an acquirer will have to inject working capital into your business on closing day, which will reduce the purchase price for the business (i.e. reduce the amount paid to you as the seller).
If you want to maximize your net proceeds on sale it is important to manage your cash flow and ensure a positive working capital position on closing. There is value associated with excess working capital by virtue of being able to either: i) liquidate current assets and extract cash from the business without affecting ongoing operations; or ii) borrow this amount from a lender (e.g. bank) using current assets as collateral and then extract the cash from the business without affecting ongoing operations.
In an actual transaction the buyer and seller will negotiate a "normalized" working capital amount required for ongoing operations (e.g. based on actual historical balances, AR and AP collection policies, inventory turns, industry averages, anticipated growth, etc.). Any amount over (under) this "normalized" working capital will be reflected as an increase (decrease) to the purchase price on closing.
One Thought For Improving Your Cash Flow
There are many ways to improve your company’s cash flow and, as a result, its value. One often overlooked tactic is to spend less on the capital assets your company needs to operate.
In the restaurant business, for example, it may take three bankruptcies at a single location before any restaurant can make money. The first owner of a restaurant walks in and pays cash for a brand new commercial kitchen thus depleting his cash reserves before opening night. Within a year, the restaurant owner runs out of cash and declares bankruptcy.
Along comes a second entrepreneur who decides to set up her restaurant at the same location and buys all of the new equipment from the first owner’s creditors for 70 cents on the dollar, figuring she has made a wonderful deal. But the outlay of cash is still too great and she too is out of business within a year.
It’s not until the third owner comes along that the location actually survives. He saves his cash by buying all of the equipment off the second owner for 10 cents on the dollar.
The moral of the story - find a way to reduce the cash you spend on your capital assets. Can you buy your equipment used at an auction or online? Can you share a very expensive piece of machinery with another non-competitive business? Can you rent instead of buying?
Profits are a very important factor in determining your company’s value but so is the cash your company generates. Don’t neglect your company’s cash flow and working capital if you want to maximize business value and ultimately the net proceeds you receive on the sale of your business.