How Do Cash Flow Statements Help in a Business Valuation?
The cash flow statement is a document that provides the business with a blueprint for normal operations.
The cash flow statement is an important document that provides the reader with the business’s current, predicted, and forecasted operating performance. It’s also one of the fundamental elements in determining the business valuation of a company. Therefore, it is necessary to understand how the statement contributes to this process. Let us take a closer look at how the cash flow statement is used in determining the business valuation.
Cash Flow Statement and Business Valuation
The cash flow statement is a document that provides the business with a blueprint for normal operations. In order to use this blueprint, it is necessary to understand how the cash flow statement is used as an integral part of the business valuation process. This article details how the cash flow statement is used in the business valuation process.
What is a Cash Flow Statement?
A cash flow statement, also known as a statement of cash flows (or financial statements), shows the sources and uses of cash over a specified period. It often goes beyond this period, reflecting the impact of deferred revenue and capital expenditures as well. It is more than a simple listing of its income statement and balance sheet. Rather, it is a statement analysis of the cash that flows into and out of business due to its operations.
The statement is an important part of the business valuation process because it allows the investor to closer look at a company’s short-term and long-term cash flow. The statement gives the investor insight into the following three areas:
- Forecasting of cash-flow – Cash flow forecasting is the act of predicting how a business will use cash. Forecasting allows investors to determine if the underlying companies have a positive cash flow or negative cash flow in their hands while they are making investment decisions. The key to successful forecasting is understanding its business model and its basic operating characteristics.
- Assessing the company’s operating performance – Just as the cash flow forecast is input in evaluating the profitability of a business, it is also used in determining a company’s overall financial position. The cash-flow statement can help determine how successful a business is and how strong its ability to expand or decline overtime is.
- Determining the company’s value – A company’s value is impacted by several factors, both outside and inside the business itself. The cash flow statement is one of many pieces of information an investor looks at when determining how much to pay for a given share of stock. Just as strategic investors look at their businesses using benchmarks, they also use these same benchmarks to determine how much to pay for a given share of stock in another business.
Cash Flow Statement as a Business Financial Statement
The cash flow statement is one of the few financial statements generated before recording changes in net income. This means it can be a more accurate reflection of a business going on over a specific period. The statement will show whether the company has positive or negative cash flows over the specified period. It will also show how this trend compares to previous periods, helping a potential investor predict how cash flows might look in future periods. This helps to provide a better understanding of the company’s financial situation.
What Does a Cash Flow Statement Include?
A cash flow statement is divided into four sections: operating activities, investing activities, financing activities, and non-cash activities.
Cash from Operating Activities
Operating activities will include the business’ operations, including its principal activities. In most cases, it will also include the company’s investments in fixed assets and intangible assets, such as patents and trademarks.
Other details included in this section are:
- salaries and wages
- amortization of other intangible assets
- depreciation in land and buildings
- interest expense on long-term borrowings or short-term liabilities
- taxes paid or accrued on income or gains from other non-cash transactions or items of income or expense that aren’t included in income by the company (such as the depreciation of some items)
- dividends declared, transfers to other parts of the firm (accounting entries), and changes in accounts receivable
Cash from Investing Activities
In this section, investing activities will include the purchases and sales of long-term assets and the proceeds used to purchase these assets. It will also include long-term debt secured by notes payable or bonds payable.
It will also include cash paid when investing in short-term assets, such as sales of securities. Cash is paid for purchases made, and the cost of goods sold is also included. Therefore, any depreciation of fixed assets and amortization of intangible assets will also be included in this section.
Cash from Financing Activities
In this section, financing activities will show cash generated from the use of long-term debt and other borrowings, as well as proceeds received through the issuance of long-term obligations, notes payable, or bonds payable.
This is usually the largest section of the statement. It shows all sources and uses of funds raised by a business by borrowing or issuing new debt or equity securities. The net change in long-term debt then gives a picture of how much funds have been raised or repaid during the period; this may give an investor an idea of whether funding needs should increase or decline.
Disclosure of Non-cash Activities
A non-cash event is any accounting entry that does not result in cash changing hands. The cash flow statement will disclose any transactions recorded in the accounting records but don’t actually change the company’s cash balance.
This disclosure is important as it demonstrates how much of a company’s assets would be available to repay debt, equity investors, or other creditors or continue operations before recording a non-cash activity.
This section may give an idea about borrowings and repayments made on long-term liabilities using short-term loans; it also shows the net change of adjustments made to long-term liabilities.
Cash flow statement analysis should be combined with other financial statement analysis to a better understanding of the business and an analysis of the business’s industry and the economy.
How to Calculate the Cash Flow of a Company?
The cash flow statement methods can be calculated using the direct and the indirect method.
- Direct Cash Flow Method – The direct method adds up all the different types of cash payments and receipts, including cash payments to suppliers, cash receipts from customers, and cash payments as wages. The direct method is the one adopted by most companies and used to prepare their balance sheets. This cash flow statement method of calculating the cash flow is simple and easy to understand.
- Indirect Cash Flow Method – The indirect method calculates cash flow by adjusting net income by adding or subtracting the differences resulting from non-cash transactions. For example, amortization of assets or the depreciation of assets is a non-cash transaction. Companies that use the indirect method to calculate cash flow usually include this information in their notes to the financial statements. Companies with a large asset base use this cash flow statement method and need to amortize assets as part of their normal business operations. Since most companies using this method provide details on how they arrived at their cash flow numbers, an investment decision can be made after understanding its overall financial situation.
Importance of Cash Flow Statement for a Business
The cash flow statements are important for the business for various reasons, which are discussed as follows:
- Planning for the short term – A business should use its statement to identify cash needs and the amounts of cash it must have to run a profitable business. The statement can be used as a guideline for the short-term analysis.
- Spending money details – A cash flow statement will show information such as where and how the company is spending money, which can help make decisions about the allocation of resources.
- Excess cash – It will show the amount of cash left after the business has made all its investments. The excess cash will be invested long-term to generate profits and needs to be retained for future use.
- Cash planning results – It will show the result of cash flow planning which will give an idea about the amount of cash that a firm should have in its bank account or other financial securities.
- Planning for the long term – Cash flow statements can be used to identify the amount of cash needed to finance a company’s long-term growth. A firm uses these statements to determine whether it can afford new projects and investments.
- Cash balance – It will show the exact amount of cash left at the end of the working period. It will also show the amount of cash that a company has available for borrowings or investments during this period.
- Analyze working capital – A firm’s cash flow statement should be analyzed to show how much money it has left after meeting its working capital requirements. The statement will show the difference between working capital and fixed assets. This shows how much cash a firm has available for operations.
Example of Cash Flow Statement
As an example of a cash flow statement, let us look at the cash flows of a fictitious company, XYZ Ltd.
The cash flow from operations for the year ended 31 December 2017 was $200,000. The cash flow from investing is $50,000. Cash flow from financing is $10,000. Therefore, the cash flow statement for the year ended 31 December 2017 is $160,000.
From the above example, we can see that cash flow from operations is the sum of the total revenue minus all expenses. The cash flow from investing is the addition of all investments, additions to property and equipment, and total acquisitions during the period. The cash flow from financing is the sum of all financing activities during the period.
Overview on Business Valuation
Business valuation is a process that attempts to estimate the present value of cash flows and other economic values for a business using a variety of assumptions regarding risks, growth, competitive strength, and other factors.
Importance of Business Valuation
Business valuation is an important process since it can help a business or a potential investor to assess the relative value of a specific company or business segment. Here are some of the advantages of business valuation:
- Decision making – The estimate of value helps a company decide whether to sell its business, raise new capital by selling stock, or enter into a merger.
- Investment decision – The company’s value is used in making investment decisions where a firm’s cash flow and investments are compared to its debt and capital structure. The investment decision involves whether or not the price paid for an asset is above the cost of borrowing.
- Benchmarking – Comparing estimates of value between competing businesses is important in deciding whether or not a firm should continue to exist as an independent entity or be acquired by another company.
- Growth opportunity – Business valuation can be used to evaluate the value of a firm’s stock. The estimate of value may also be used in comparing the performance of other companies to a firm.
- Long-term financial planning – Financial planning is important to avoid future business problems by indicating future cash flow needs, return on investment, and long-term debt obligations.
Role of Cash Flow Statement in Business Valuation
Business valuation is often based on cash flow modeling. The statement is used to predict corporate cash flow, which can then be used in the valuation process using different valuation methods. The statement is an important document in business valuation because it is one of the most reliable and relevant sources of information for investors, creditors, and managers.
The statement provides a consistent and timely indication of the company’s cash flow performance. A cash flow statement provides information about the company’s cash generated from or used in various activities. As a result, the cash flow statement is helpful to determine if a specific valuation method is appropriate for making accurate business valuations.
How Does a Cash Flow Statement Help Raise Capital for a Business?
Cash flow statements help raise capital by showing the strength of a company’s financial position. Companies generally need cash to operate. Most businesses have short-term financial needs but long-term needs for both capital and growth.
If a firm’s assets cannot be liquidated quickly enough to meet its short-term needs, the business can issue stock or bonds to raise capital. This temporary financial support will allow the company to operate until it can sell equipment, property, or other assets to pay off outstanding debts. Following are the major types of cash flow.
- Cash Flow from Operations – The cash flow statement method shows the operating cash flow that a company generates to pay for ongoing expenses. If a company uses its cash flow to buy new machines and other equipment, the capital expenditures will be taken from the beginning of the period. The net cash flow from operations can then be used in a valuation model for estimating value per share.
- Cash Flow from Investing – The cash flow statement also shows the number of capital expenditures that a company makes on new machines, equipment, and building construction. The net cash flow from investing can be used in a valuation model for estimating value per share.
- Cash Flow from Financing – The statement also shows the number of funds that an individual or group takes out to purchase stock for investment purposes. These funds are then added to the company’s total equity and reduce future debt obligations. If a business borrows money from its bank, we can refer to this transaction as increasing debt obligations and interest expenses.
Get Experts Help in Business Valuation to Raise Capital with Eqvista!
The cash flow statement is a critical operational management and financial analysis component. To maintain a stable and successful organization, it is necessary for companies to maintain a high level of financial performance, and a business valuation can help in this regard. Eqvista offers business valuations conducted by NACVA certified valuation analysts. To learn more about our valuation services, contact us today and get a free consultation.