Valuations: Create more cash to improve value

A. Being a financially sound and healthy company involves a lot more than simply turning a profit on paper. For-profit businesses shouldn't simply strive for a positive net income. They should strive for positive cash flow and a strong balance sheet in order to  maximize the value of their business. Profit on the income statement is relatively meaningless if, at the end of the accounting period, the business has less cash in the bank than it did at the beginning. It is therefore critical to understand what metrics, ratios and financial levers can be utilized to create cash.

Maintaining financial health is a product of financial intelligence, which consists of:

• Understanding the foundation of the business (company goals and financial measurement);

• Understanding the art and nuances of financial statements (rules, estimates and assumptions);

• Understanding the analysis (using numbers to make decisions); and

• Understanding the big picture (putting the numbers in context).

Financial health can be measured in four primary ways: financial statements, financial ratios, benchmarking and business valuation. Ongoing calculation, monitoring and benchmarking of key financial ratios are the key to deciphering what those financial statements are telling you about the business. Profitability ratios (return on sales and net sales to inventory), liquidity (current and working capital ratios), productivity (revenue per FTE employee), and debt ratios (debt to equity) are the four key areas you should focus on.

In terms of cash flow management, measuring and improving working capital is likely the best way to create cash. Working capital is loosely defined as current assets less current liabilities. The most important pieces of the working capital equation are AR, inventory and AP. For a typical company with $1M in annual revenue, decreasing both DSO and days in inventory by 10 days, and increasing days payable outstanding can create an extra $50-$75K in cash per year.  Creating more cash can reduce reliance on outside financing or the need to sell equity, and ultimately increases the value.

Craig Hittle is senior manager of the health care team at Somerset CPAs, PC. Reach him at chittle@somersetcpas.com or 317-472-2150.