Valuation methodology recognizes cash is king. Generating cash with higher earnings tends to require time. It takes time for pricing and product strategies to take root, time for a brand to garner prestige, time for operating efficiencies to be realized. What if you would like to positively impact the valuation of your organization this year? We have good news for you. You have the ability to make current year improvements to your valuation by how you manage free cash flow.
Free cash flow represents the cash flow generated by a company. Distilled to its parts, free cash flow is essentially net profit after tax, plus depreciation and amortization, less capital expenditures and working capital. Capital expenditures and working capital provide two areas where careful management can positively impact valuation.
Let’s take a closer look at capital expenditures. Almost universally, revenue growth requires some level of capital investment. Manufacturing companies purchase new machines to expand capacity, construction companies purchase new equipment to take on larger-scale projects, and technology companies might expand office space to make room for new staff. These investments are necessary to support sustainable long-term growth.
Owners and managers can positively influence valuation by thoughtfully managing capex requirements and differentiating between true business needs and ‘nice-to-haves.’ For example, could a used machine accomplish the same result as a brand-new machine? Could certain infrequently-used construction equipment be rented more economically than purchased? Does the new office space require granite countertops, or would quartz do just fine?
We would not recommend slashing capital expenditures in the short-term in an attempt to positively impact valuation. In fact, drastic short-term measures would have the opposite impact. However, you might want to think twice before spending through your entire capex budget just because we have reached the end of the year. By making thoughtful decisions to invest in capital expenditures that will truly boost performance, management can positively impact valuation in both the near-term and long-term.
Working capital represents another integral component of cash flow. Working capital represents current assets, including accounts receivable and inventory, minus current liabilities, like accounts payable. Growing companies typically require additional investment in working capital. For example, increases in accounts receivable tend to outpace that of accounts payable as an organization expands. This equates to a drain on the cash resources of a company, resulting in a reduction of free cash flow.
With an understanding of how receivables and payables impact cash flow, owners and managers can implement certain measures to improve collections and slow payables. We would recommend starting with a review of terms. Perhaps you can encourage faster collections by offering a discount for early payments or by directing more focus toward collection efforts. When it comes to payables, are you utilizing the maximum payment terms offered by your company’s suppliers?
Benchmarking working capital through an analysis of key ratios provides a window of insight into the extent of room a company has for improvement. Working capital metrics, specifically ‘days in accounts receivable’ and ‘days in accounts payable’ are common measurements for comparison and trending. Inventory, and the ‘days in inventory’ metric is another area where diligent asset management can improve cash flow.
If you are interested in learning more about value drivers and ways to improve valuation, drop us a note. We’d be glad to provide a view into benchmarks for your industry.