Enhancing Business Value
measure and manage the value of a company, one needs to understand the
fundamental principles of value creation
Business interests frequently change hands as the
result of either proactive planning or unexpected events, such as litigation,
death or shareholder buyouts. Therefore, it is important to take steps to
maximize the value of a business even if the owners do not anticipate a sale in
the near future. The focus of this article is on how actions taken
by management and owners can enhance their company’s value.
The value of a business is typically determined by
the following two factors: the amount of cash the business is expected to
generate for its owners; and the probability that the business will, in fact,
generate the expected cash (i.e., the riskiness of those cash flows).
To effectively measure and manage the value of a
company, one needs to understand the fundamental principles of value creation. A
business’s value is based on the cash flow expected to be generated in the
future, not what it has generated in the past. In many cases, historical results
are a good indicator of what can be expected in the future, but many things can
impact the future negatively or positively.
Thus, in order to create value, it is important to
pursue strategies that increase the net cash flow and/or reduce the risk. As
most business owners know, applying these concepts in practice is much more
difficult than identifying them in theory.
A comparison of a company to its industry is the
place where this process often begins. The idea is to determine how risky a
business is when compared to other companies in the industry and to look for
opportunities to increase cash flow.
Major trends in the industry with respect to
customer preferences and the impact of new technology may be revealed during
this comparison. It is through this analysis that the company’s strengths,
weaknesses, opportunities and threats are identified. It is the combination of
these factors that determine a company’s risk profile.
Even though it seems that identifying these factors
is something every business manager would normally do (even on an informal
basis), many managers get so caught up in the company’s daily problems that they
fail to set aside time to focus on the “big picture.”
Once these attributes are identified, the company
can better use this information to think strategically, exploiting opportunities
and strengths, while taking steps to minimize or compensate for weaknesses.
Maximizing Income or Cash Flow
To maximize income or cash flow, a business should:
improve operating efficiency and increase
develop a strong and organized marketing
department or marketing plan;
avoid excessive leverage (while some debt can
increase returns to shareholders, excessive debt may cause financial
distress during lean times);
avoid using business assets for non-business
avoid hiring unneeded family members;
concentrate on cash flow management (even small
changes in accounts receivable collection periods or inventory turnover
ratios can have a significant impact on cash flow and, hence, value);
divest assets that earn a rate of return less
than the company’s cost of capital; and
manage and maximize sustainable growth.
Reducing Operating Risk
To reduce operating risks, the owner should first
identify those risk elements that most affect the business, then monitor, manage
and control them. Risk elements may be broken down into the following primary
Competition. Secure patent and copyright protection of products,
services and processes. Improve product and service quality. Maintain pricing
competitiveness. Consider the applicability of employment contracts and
non-compete agreements for key personnel.
Increase the company’s liquidity and working capital position. Build equity.
Refrain from stripping out the company’s retained earnings at the expense of
leaving the company “cash poor” and possibly sacrificing future growth
Management ability and depth.
Improve the condition and appearance of the business’s facilities. Maintain the
quality of business records, including, but not limited to, contracts, financial
statements, income tax returns and employee files. Strive to reduce employee
turnover, especially at key positions. The development of management depth is
also important, which for smaller companies can often be accomplished through
cross-training of existing staff.
Profitability and stability of
earnings. Avoid accounting techniques
that manipulate earnings and result in volatile reported income from year to
year. To the extent possible, develop diversity in the company’s clients or
customer base (i.e., reduce reliance on a few large customers). If the business
is going to be sold, the owner should consider his or her willingness to enter
into a non-compete agreement.
Each of the general risk categories described above
are part of the specific company risk component included in the development of
an appropriate capitalization or discount rate. Generally speaking, the lower
the capitalization rate, the higher the resulting value of the company will be.
Another way of reducing the cost of capital is to alter the company’s financing
mix and move toward an optimal amount of leverage.
Business value is often determined using the income
approach, so a business owner can improve the value and salability of the
business by increasing its earnings and cash flow and establishing
sustainability and quality of earnings and cash flow. The business owner can
also increase the value of the business by reducing its operating and financial
Since a business is often the most valuable asset
in the business owner’s personal portfolio, it stands to reason that he or she
should manage the business with an eye toward maximizing value.