Why Cash flow Matters (besides the obvious)
We will sometimes refer to cash flow as the Valuation Teeter-Totter because the value of your company is going to have a direct relationship with how much cash your company throws off.
I’m not talking about the profits at the bottom of a profit and loss statement. I’m talking about the literal cash coming into your bank account. and the more cash you can get your company generating, the more valuable it is going to be to an acquirer.
Why is that?
Essentially, when an acquirer goes to buy your company, they are going to have to write two checks. One check is the check to you the owner to pay for your company. But there is a second check they need to write, and that second check is for working capital. Essentially the money your company needs to operate the moment the new buyer takes over your business. Those two things work in opposite directions. In other words, the more cash your company needs to operate, the more working capital the acquirer is going to need to inject into the business when they buy it, the less the business is worth to them.
The opposite is also true – the more cash your company generates and the less working capital it needs, the more valuable it is going to be.
Let’s go through a hypothetical situation. Imagine you are buying a business and you have $5M to spend to buy that business. Again, you have to write two checks – one to the owner, one to the working capital. If you have $5M to buy this business, and you have to invest just $200,000 into working capital, then you have got $4.8M left to pay the owner.
Now imagine a second business that sucks up a lot of cash. You need to buy a lot of inventory, you need to buy a lot of very expensive equipment and machinery, and so a buyer is looking at this business and saying great, I’ve got $5M to spend, but I’m going to have to inject $3M into the business in working capital. Well, then you only have 2M left to pay the owner. That’s why cash flow matters.
So the more you can get your company generating cash, the more valuable it is going to be to an acquirer.