August 2003

Enhancing Business Value

To effectively 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.

Creating 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 operating margins;
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 purposes;
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 categories:

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.

Financial strength. 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 opportunities.

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.

Summary

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 risk.

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. ■