In a previous article, Grassi’s Valuation team discussed the concept of normalized and sustainable earnings as an important metric in assessing the value of your business. The going concern (or total) value of a business is dependent on future results, and when estimating or forecasting future performance, any non-operating, discretionary and/or non-recurring items must be normalized from past results to provide a realistic basis on which to project the future.
These normalization adjustments are necessary to eliminate items that do not reflect the ongoing operations of the business, such as the pandemic, which resulted in wild swings in sales and earnings. And while normalized earnings can provide a basis for valuation, a valuation analysis will frequently determine that normalized cash flow is an even better measure of the company’s value.
Earnings vs. Cash Flow
Earnings, which may include many non-cash items such as depreciation and amortization expenses and bad debt expense, do not give a realistic picture of the cash flow available to pay to the owners and other stakeholders as a return on their investment. Investors in a business receive value in the form of cash – interest and principal payments to debtholders, and dividends or other distributions to equity holders.
It is therefore critical to adjust earnings for non-cash items, as well as for non-expense cash items, to isolate the cash flow and determine the business’ ability to service its debt and make distributions to equity holders.
Benefits of Normalized Cash Flow
Understanding your business’s normalized cash flow is important for multiple reasons. It is a vital component of valuation, which is important for raising equity financing, paying equity-based compensation, and transferring interests in the business. It is also relied upon by lenders to assess a business’ creditworthiness, evaluate how much debt a business can support, determine the terms of such debt, and consider what collateral and other loan covenants may be necessary. It is also considered by vendors, in determining how much credit to extend for purchases, and on what terms.
Finally, it is an important component of business planning and forecasting, as a company’s ability to support its operations and fund expansion relies on expected future cash flow. For all stakeholders in a business, the value they receive depends on its ability to generate the cash to meet its obligations and provide a return to investors. Moving from reported or forecasted earnings to a measure of cash flow is key in determining the company’s true value.
Converting Earnings to Cash Flow
Once an estimate of normalized historical or projected earnings has been developed, further adjustments must be made to convert the earnings stream into a measure of cash flow. These adjustments include:
- Depreciation and Amortization – These non-cash expenses may have a significant impact on the income statement, particularly for capital intensive businesses, but do not directly impact the cash flow available to investors. Earnings must be adjusted by adding back these expenses to eliminate their non-cash impact on reported earnings.
- Capital Expenditures – Depreciation and amortization reflect the expensing, over time, of investments in fixed assets and other assets used to support a business’s operations. This accounting treatment allows for companies to make new investment without expensing the cost immediately. While capital expenditures do not immediately impact the income statement, they do immediately impact the cash flow of the business. Just as we have adjusted reported earnings to eliminate non-cash depreciation and amortization expense, we must similarly make an adjustment to reflect the cash expense of new investment. In projecting capital expenditures, there are two components of investment to consider:
- Replacement expenditures – As equipment and other property wear out, they must be replaced. Projected depreciation can be a basis upon which to project replacement expenditures, as depreciation reflects the decline in value of existing assets over time and approximates the value of items that will require replacement.
- New capital expenditures – Beyond the replacement of existing equipment, many businesses must invest in new machines and other equipment to support growing operations or expansion into new business lines. To project future cash flows, one must understand the level of investment in new equipment that will be needed to support the business’ growth. Early-stage companies in particular often require significant new investment in property and equipment, and cash flow would be significantly overstated if such expenditures are not deducted from projected earnings. Projected depreciation must also be adjusted to reflect the impact of adding new, depreciable assets.
- Investment in Working Capital – Businesses require a certain level of capital to support their operations. The timing of inflows and outflows of cash are often mismatched, and a business must always have sufficient capital to cover expenses such as rent and payroll, pay vendors, make tax payments, and meet debt obligations. As a business grows, so too does its need for working capital, and when revenues are projected to increase over time, projected cash flows must reflect the need to retain additional capital to support the revenue growth. Such incremental working capital can be estimated as a percentage of revenue growth, based on the company’s historical level of working capital, or on industry data.
- Excess or Deficit Working Capital – At any point in time, a business may have working capital greater or less than the level needed to support its operations (as estimated based on a normalized required level). Events such as the receipt of money under the Employment Retention Credit Program may result in a business holding excess working capital, while a significant unexpected repair expense might result in a deficit of working capital. Separate from projected cash flows, such excess or deficit can be treated as a non-operating asset or liability and added to the value of the business which has been derived from a projected cash flow analysis.
While less common, the following adjustments are also appropriate, when applicable:
- Equity-based Compensation – Many companies, particularly early-stage companies, include equity, in the form of direct equity, restricted stock units, warrants, or other contingent equity claims, in compensation paid to employees and management. Pursuant to Internal Revenue Code Section 409A, such equity-based units are reported as compensation expense for the business. This non-cash component of reported compensation should be added back to determine cash flow. Note however, that in valuing the equity of the business, outstanding options, warrants, and other contingent securities must be considered in allocating value between different classes of equity. Keep in mind there are alternative points of view on adding equity compensation to earnings. The alternative argument is that equity compensation is offered by early-stage companies in lieu of cash compensation that a more established company would pay.
- Goodwill Impairment – A company’s balance sheet may reflect goodwill related to a prior acquisition in which the purchase price exceeded the value of identifiable tangible and intangible assets. Under Accounting Standards Codification No. 350, such goodwill must be tested to determine if the reported value still reflects the fair value of the acquired asset. If the fair value of the asset has fallen below the booked amount of goodwill, the company must take an “impairment charge,” and recognize an expense in the amount by which the goodwill has become impaired. An expense of this nature should be eliminated when estimating the company’s cash flow.
Calculating Cash Flow
The basic net cash flow model is presented below:
|Normalized operating income|
|+||Normalized non-cash charges|
|=||Gross cash flow|
|–||Anticipated capital expenditures|
|+/-||Incremental working capital|
|=||Net cash flow to invested capital|
|+/-||Interest, debt borrowings or repayments|
|–||Preferred stock dividends|
|=||Net cash flow to common equity|
Click here to read the various steps for determining normalized earnings in our prior article.
In every transaction or investment situation, the buyer (or investor) will try to understand normal levels of investment in equipment and whether a significant new investment in equipment is required to sustain normal operations. Net working capital targets are negotiated in most M&A transactions because a “normal” amount of net working capital is required to sustain “normal” operations. This sounds easy enough in theory, but in reality is messy and unpredictable. Overlay the volatility of the past three years and supply chain problems, and “normal” is not so easy to define. If a company had to buy excess inventory due to supply shortages, is normal net working capital now a greater number? How can an owner document adequacy of investment in equipment or get credit for a large investment in equipment that has yet to be turned on?
These are the types of questions our Valuation, Transaction, and CFO Advisory professionals help business owners answer every day. For more information on cash flow projections and how they can help you plan more confidently for 2023, please reach out to your Grassi advisor or contact Indah Abadi or Michael Rothstein of our Valuation Team.