Cash Rules and Income Comes Second
August 18, 2009
There’s one very important lesson I learned while earning my MBA, which I keep in mind in my personal life. When valuating a business, figuring out what a company is worth, there are a couple of different ways to come to a figure. The easiest method is calculating the fair market value of all of the company’s assets, subtract its debt, and the difference is its value. You can also look at accounting ratios and future earnings, and then it gets really complicated. But the best way to know if a business is worth buying is by analyzing its cash-flow and how easily it generates free cash. When payroll is paid, when your accounts payable are up to date, is there still cash left in the bank? Is the cash reserve increasing over time? I think the best way to valuate a business is by looking at its free cash flow.
Suppose you are evaluating a potential purchase of a restaurant. The current owners invested over a million dollars in the kitchen and dining room, but it makes no cash profit. Is the restaurant worth a million dollars, as the value of its assets would suggest? Certainly not; not if it does not produce cash. Read more