When people think about what drives value in a business, profitability comes to mind, and it is the most important driver of value to a business. However, there are other ways that are often overlooked. To increase value in pure finance terms, the different levers fit into three basic categories under what is commonly known as The Gordon Growth Model:
- Increasing the benefit stream generated (i.e., cash flows)
- Lowering the cost of capital required to attract investors/stakeholders
- Increasing the growth rate of the business
Increasing profitability is the most common way to increase the benefit stream, but it is not the only way. Maximizing asset turnover or utilization also generates cash flow. Increasing the company’s working capital efficiency will increase cash flow. Minimizing the amount of cash tied up in the conversion cycle (receivables + inventory – payables) is also, important. Additionally, efficient use of your property and equipment enhances cash flow. Idle or underutilized assets tie up resources that could be better deployed elsewhere.
Optimum use of leverage is another way to increase enterprise value. Debt is generally an inexpensive source of capital to a business, and the interest payments are tax deductible. The proper mix of equity and debt in a capital structure generates a lower weighted average cost of capital (WACC). A key issue to point out in regards to the cost of capital is that it is correlated to risk. Too much debt in a business increases risk, and the cost of capital goes up. Also, not enough liquidity in a business increases risk and the cost of capital goes up.
Finally, the growth rate of the business is a key element of increasing value. We often look at the growth rate in sales or revenue to determine this metric, but in the pure finance models, this measurement is quantified in earnings. Therefore, growth in the top line, without a corresponding increase in earnings, is really not increasing value.
In summary, evaluating your performance in all areas that increase value in your business is important. If you would like to know more about these areas or need assistance in valuing your business, please contact John Waybright at (614) 586-7118 or by email.
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