Small Business Finance and Valuation
by Rick Nason and Dan Nordqvist
A finance professor and a CPA have teamed up to explain finance and risk management concepts specifically for small business, defined as assets under $5 million. They acknowledge that the objectives of small business owners often differ from those of a Fortune 500 CFO, whose focus is typically maximizing shareholder value. Freedom, peace of mind, and other quality of life issues may be more important to a small business owner.
Financial Statements. The authors emphasize “interpreting a set of managerially based financial statements that aid in the management of the business as opposed to developing financial statements solely for regulatory or tax purposes… Financial statements can quickly become complex and hard to understand so it is important that they are created with the end user in mind.”
“The Cash Flow Statement breaks the cash flows of the business into three separate activities of the firm: Operating Activities, Investing Activities, and Financing Activities… One of the key distortions that the Statement of Cash Flows illustrates and that the Income Statement can disguise is the overuse of Financing Activities to hide an unsustainable amount of negative cash flows from Operating Activities.”
Trends. “A common technique to aid in the spotting of trends in the financial statements is to convert the financial statements into what is known as ‘common size’ statements. To do this, each of the figures of the Income Statement are calculated as a percentage of Sales, and all of the figures of the Balance Sheet are shown as a percentage of Total Assets.” But beware: “Just when you think it’s a trend, you find out it’s a cycle… Naively assuming trends will continue forever will likely only lead to nasty surprises.”
Forecasting and Planning. “The primary purpose for a financial forecast and plan is to understand the amount of financing that the business needs to carry out its operational plan. Particularly when it comes to expansion, or to capital budgeting projects, managers are quite good at tallying the amount needed for equipment, but much less so when it comes to the financing needs for human resources and working capital [including] appropriate staffing levels… Finally, the goal, or objective, for the business should be based on the forecast and not the other way around.”
Trade Credit. “Trade credit is generally expressed in a form such a 3/10 net 50. This means that the supplier is granting the choice to the business of paying within 10 days and getting a 3 percent discount or paying the invoice in full in 50 days. At first blush it appears that the cost of this financing is simply the foregone 3 percent discount. However, it needs to be realized that the financing is only for 40 days—the difference between paying within 10 days or 50 days. When this short-term financing is annualized, its true cost is a whopping 32 percent!”
Working Capital Management. “Proper projection of working capital need is one of the trickiest aspects of a capital budgeting analysis… As sales increase, the working capital needs increase, and if the working capital needs increase to the point that the working capital can no longer be financed, then the company will go bankrupt, even though they are very profitable.” The authors explain how to calculate the cash conversion cycle. A lower number is better; a negative number indicates that cash from sales is received prior to paying suppliers.
Capital Budgeting. “There are two main capital budgeting techniques… the Payback Rule and the Net Present Value Rule… The Payback Rule for capital budgeting asks a simple questions: whether or not the project will pay back the initial capital expenditure within a given time frame.”
“The Net Present Value (NPV) Rule is a more robust as well as conceptually correct rule for capital budgeting than the Payback Rule. The NPV Rule starts by calculating the present value of all of the cash flows associated with the projects. The discount rate is the cost of capital, or, more accurately, the Weighted Average Cost of Capital (WACC)… After calculating the NPV, the NPV Rule becomes obvious: accept all projects whose NPV is positive, and reject all projects whose NPV is negative… As the NPV analysis gives the value added, it can also be used to rank various projects.”
“Ideas should chase money; money should not chase ideas… Simply because a business finds itself in the fortunate situation that it has excess cash availability, it does not necessarily mean that it should go chasing investments. Instead, the business should wait until it has excellent capital budgeting projects and then source the cash necessary to make the investment.”
Business Valuation. Understanding what drives valuation is useful to owners who may eventually want to sell the business. Valuation is driven by a comparable multiple of Earnings Before Interest, Taxes and Depreciation (EBITDA). “EBITDA is basically an approximation of the cash being generated by the business.” A comparable business “is one that has similar risk, as represented by the level of stability of the Net Earnings or New Operating Cash Flows, as well as similar growth opportunities.” Lower volatility, high growth prospects, and barriers to entry increase valuation. Also the price per share of a controlling interest (at least 51%) is worth more than a minority interest; “this extra value is called a control premium.” The problem is that most small business transactions are private and recent transaction data may not be available. “For some industries… these multiples are relatively well known,” however the book does not include any examples. Ultimately, the value is what a buyer is willing to pay.
Risk Management. “Small businesses operate on very different principles of risk. Small businesses do not have the luxury of having natural risk diversification through scale of products, scope, or geographical diversification.” On the other hand, “two advantages that small business have in risk management is their closeness to their markets and their nimbleness.”
“Risk management is managing in such a way as to increase the probability and magnitude of good risk events happening while also managing so as to decrease the probability and severity of bad risk events occurring… Put another way, risk management can perhaps most easily be implemented by simply doing all management tasks with a risk lens.” Types of risk include strategic risk, financial risk, credit risk, cyber risk, legal and regulatory risk, and reputational risk.
“Remember that risk is two-dimensional. There is the probability factor, and there is also the impact factor.” A risk map is a tool for assessing risk along these axes. Other techniques include a backward-looking postmortem to review both good and bad risk events as well as forward-looking “premortem” scenario analysis.
“If finance and management was a science, then all businesses would be run by a bot and there would not be a need for managers in the first place. Data analysis helps in decision making, but ultimately the intuition, humility, and managerial flexibility of the manager will trump cold, hard, analytical data analysis.”
Nason, Rick, and Dan Nordqvist. Small Business Finance and Valuation. New York: Business Expert Press, 2021. Buy from Amazon.com
Disclosure: As an Amazon Associate I earn from qualifying purchases.