By Dean Demeyer
Chartered Accountant, & Licensed Business Broker
One of the most difficult concepts for a broker, adviser or accountant to explain to businesses owners is the amount of stock and equipment they carry typically has no direct impact on the value of the business.
Stock and equipment are tangible assets required to derive revenue and net profit. What is important though is the amount of cash flow generated from these tangible assets, not the individual value of these tangible assets.
To understand this concept, let’s look at a practical example.
If we compare two businesses, one is an earthmoving company with $500,000 of physical earthmoving equipment, the other is plastering company with a few employees and only $45,000 in tools, equipment and stock.
The earthmovers derive net cash flows of $300,000, and the plasterers generate $750,000 of net cash flow. Even though the earthmoving company has more combined cash flow and tangible assets, most accountants would recommend the plastering business because of its significantly stronger cash flow.
Knowledgeable buyers are interested in a business’s cash flow and insist the assets used to generate the profit are included in the sales price.
The sale price is almost always derived from the net cash flow of the business, multiplied by a factor for perceived risk. So, let me clarify, once that cash flow/multiple price is determined, all the physical assets are included in that price.
Let’s assume both businesses above generated the same net cash flow of $250,000, a shrewd investor would buy the plastering business as it employs fewer physical assets to generate the same return.
The earthmoving company is possibly holding redundant equipment that they should sell off prior to sale. Why, because they won’t receive any extra money in the sale price for it. It is very common to see appraisals of businesses where the cash flow/multiple method is used and then stock is added-on. This does not make good business sense.
A buyer would essentially be paying more for the same level of earnings under this philosophy – and they usually don’t. Don’t look at the business-for-sale websites though and see businesses listed for sale as $$$ + Stock at Value and think this is an add-on situation.
Generally, businesses are listed this way because stock levels fluctuate throughout the year or month. For example, if a retail business’s profit is $150,000 and the perceived risk multiplier is 1.5, the sale price would be $225,000.
If they carry approximately $80,000 of stock, this business would be listed as $145,000 + Stock at Value, allowing for those stock level variations.
Buyers and their advisors need to exercise caution. Occasionally assets and stock are used to appraise sale value where the business is not profitable.
Typically, buyers are not interested in these businesses because the seller has proven the combination of these assets can’t turn a profit.
However, they may be attractive to a similar business who knows the value of the assets and has proven expertise to make money from the assets