For many entrepreneurs, their business represents their largest financial asset. Business owners may not have a sense of the factors that underpin their company’s worth. It’s critical to understand what drives this value and what could be draining it from your business, so in this two-part blog series, we take a closer look at these factors.
Tangible vs. Intangible Assets
To identify what drives value in your business, it’s important to understand the two sides of value: tangible and intangible.
The tangible portion of a business’ value is comprised of assets like cash, accounts receivable, inventory or fixed assets.
The intangible portion of a business’ value is comprised of assets like brand name, supplier relationships; or proprietary formulas, technology or products.
The nature of the business or industry will dictate whether it has more tangible or intangible value. For example, most service businesses will have greater intangible value while asset-intensive businesses will have greater tangible value. Keep the nature of your business in mind as we look at some key value drivers.
1. Effective management
The unique assemblage of individual assets is what comprises a business as a whole, but the efficient and effective employment of both tangible and intangible assets is a driving force in the value of a business. Like a well-oiled machine, a valuable business will operate most efficiently when all its individual components work synergistically.
A company’s interconnectedness means that effective management in one area of the business can have positive effects on the other areas. This is why the management of a business – whether by the owner or a trusted, experienced individual or management team – is one of its most valuable assets. For example, management can implement effective controls, which reduces the possibility of fraudulent activity or poor product quality or service. This in turn can maintain or enhance brand name or reputation and help keep an effective workforce in place.
2. Cash flow
As with any other type of investment, the value of a business is measured by its ability or expectation to generate earnings. “Cash is king” is especially true in the valuation world. A business’s cash flow is the most fundamental determinant of value, and a business with stable and predictable cash flow is a valuable asset to the investor. Of course, quantifying that steady cash flow is just as important, which can only be done through the tracking and maintenance of reliable financial information.
Determining more specific value drivers may take some work and, as noted above, may depend on the type of business. A thorough and honest assessment of your business via SWOT analysis will give you an idea of what strengths to maintain and what opportunities to target, along with the weaknesses and threats we will discuss in part two of this blog series.
Factors such as customer loyalty, sales or supply agreements and proprietary machinery or equipment can all be strong value drivers for your business. Don’t overlook the external factors, such as location, regulatory and legal landscape or industry trends and changes, which could also impact your business value. Evaluating both internal and external factors and understanding how they strengthen your business can be a daunting and time-consuming task, but identifying these differentiators is an investment that will certainly pay off in the long run.
Once you recognize your business’ value drivers, you will be able to evaluate them as part of your strategic planning or key decision-making processes. A business with strong value drivers has more marketability, which in valuation terms refers to the liquidity of an investment, or the ease and expediency in which a particular investment can be sold. Business owners who establish effective management, maintain strong and stable cash flow, and possess an accurate grasp of factors affecting their organizations will likely own valuable investments.
Be sure to stay tuned to our blog in the coming weeks, when we tackle the other side of the coin: factors that can drain value from a business. In the meantime, if you’d like to get a sense of what drives your business’ value, RKL boasts Central and Eastern Pennsylvania’s largest team of credentialed valuation specialists. To enlist the guidance of an RKL expert, contact one of our local offices.
Contributed by Matthew Hartland, CPA/ABV, a manager in RKL’s Business Consulting Services Group, who specializes in providing business valuation and litigation support services. Matt also has experience in financial analysis, forensic accounting, budgets and projections, assistance with acquisition and sale of closely-held businesses, and ad hoc analysis.