HOW TO DO A Business Valuation - example CONTINUED

BUSINESS VALUATION (9/2/02)
(Continuation)

So far we have done the following:

We have visited the business.

It has been decided if you can do the evaluation yourself or outside help has been obtained.

We have the requested financial information.

We are familiar with the prices of comparable businesses and we know the industry.

It is now time to do some number crunching and look at other factors that might affect the purchase price.

It is time to decide, which valuation method we will use.

In the Old Message Board, I mentioned "cash flow from operations" as my favorite method of determining the value of the business. I am a bit biased since that phrase in hammered into your brain from the moment that they hire you as a credit analyst, and frankly that will be the source of repayment for any loan. However, I am going to try to be impartial and give you a listing of the methods at your disposal.

a) Capitalization of income. For clarification purposes lets use imaginary numbers for the laundry Eugene is interested on. (These numbers are completely made up)

Coin Laundry Income

$200,000

Dry Cleaning Income

$200,000

Total Revenue:

$400,000

Cost of Goods Sold

$100,000

Gross Profit

$300,000

Labor expense

$100,000

Utilities

$50,000

Interest Expense

$25,000

Depreciation

$25,000

Operating Expenses

$250,000

Profit Before Taxes

$50,000

Earnings Before Interest, Amort., Depreciation and Taxes EBITDA

$100,000

After this very simple income statement we have figured out that the laundry makes about $100,000 in earnings before you have to pay interest expense, deduct depreciation and pay taxes. Now you have to ask yourself a question, what kind of return do you require to put your money into this industry and this particular business. Lets say for argument sake that you require a 25% return in your investment. Then $100,000 / 0.25 = $400,000. According to this method the value of the business would be $400,000.

b) Cash flow from Operations. Cash flow not only looks at EBITDA, but actually tracks the inflow and outflow of cash from the business. Suppose that the following has also happened to the laundry during the last year.

The Dry Cleaner got a new contract, which has increased sales but at the same time has increased accounts receivable by $40,000. This affects your cash collected from sales downward by $40,000 to $360,000.

Inventory has had to grow by $15,000 to support increasing revenues and operations. In addition, the suppliers have been pressuring for prompt payment decreasing accounts payable by $20,000. These two factors have decreased cash flow further by another $35,000.

There are many factors that can affect cash flow the three listed above have reduced it by $75,000 leaving only $25,000 to cover the debt service for any kind of loan used to pay for the purchase of the business. The actual value of the business using this valuation method varies accordingly to the terms that you can get from the financing institution for the purchase.

c) Multiplier of sales / Rule of thumb. As you could read from the excerpt of the coinlaundromat.com website. Coin laundries are usually valuated at twenty times monthly gross. The rule of thumb averages may work for coin laundries whose performances are average. However, if the business expenses and profits are not right on target with industry averages, this method would result on a misleading valuation. The warnings expressed in the article apply to all types of business.

d) Asset Valuation. This method only concerns itself with the value of the assets of the business being sold.

After deciding, which valuation method to use and before putting it in practice, make yourself a list of questions about the business you are going to buy. This will help you determine the risk associated with the transaction.

Use that list that you created while visiting the business and any other thing that you want to ask the borrower.

I hope this article has helped you.

Return to the first part of this article by clicking here.

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