The difference between the calculated value of the business and the total value of its tangible assets, such as assets, stock, debts, plant and equipment (minus any debt) is the business’ goodwill. If the calculated business value is less than the tangible assets, the goodwill is negative.
Goodwill is not something that is calculated directly, but it is the result of the calculation described.
The value of goodwill is enhanced by improving the business value through factors such as handing management over to others to reduce the owner’s personal association with the business.
If accounting records are unreliable, or if the business can’t produce current financial records, any prospective buyer is likely to discount the value of the business because of the uncertainty about its real profitability. It is therefore important that a business maintains reliable records and be able to produce current records at any time.
As mentioned earlier, in looking at profitability, adjustments are commonly made for extraordinary items of income or expense, and for expenses that are discretionary or personal to the owners.
For example, if there are vehicle expenses or travel expenses for the benefit of the owner, they would be added back in determining profit. Therefore, such expenses must be readily identifiable.
The availability of financial analysis of sales by customer, product, and geographic location can also enhance value where the analysis points to a “low profit risk” due to a good mix of customers or a wide product base.
Key factor: profitability
One of the most important factors in determining value is profitability, which is closely related to cash flow. A business with dependable cash flow will also have dependable profitability.
And an increase in profit will generally lead to an increase in sale value.
This does not mean that all businesses with the same level of profitability will be valued at the same amount. Two companies can be equally profitable, even in the same market, but one will have a higher sale value than the other.
How can this be, you might ask, and it is a very good and important question.
Company A’s profitability is closely related to the owner’s personal skills and relationships, while company B’s profitability is based on product pricing, account mix and corporate culture.
In today’s marketplace, company A is probably worth less than company B, despite the same level of profitability. The reason is that with the departure of company A’s owner, it is more likely that profitability will suffer. The owner needs to be able to show the quality and skills of the rest of the staff, the contribution they make to profit, and the lack of reliance on his or her personal efforts.
Thus, while profitability is important, it is the expectation of continued profitability from the business structure itself, rather than from the ability of the present owner, that is most important.
This can come as a surprise to many vending operators who have worked hard to build the profitability of their business, but in doing so have become too personally associated with the profitability.
This is a problem with other professional services businesses as well, where the reputation of the owner is closely associated with the business’ success. The owner needs to reduce his or her influence on the profitability of the business in order to maximize its sale value.
This will include establishing a management team, improving formality of management, introducing customers to others in the business, keeping records of customer contacts, and excluding the owner’s name from the business.
A business that has good management systems, is well located and enjoys a long-standing reputation should be able to maintain its profits. Such a business would usually be said to have a low risk for a new owner.
Because of this low risk, the sale value of the business will be higher than that of a business where there is a high risk that the profit will not be sustained.
If a valuation identifies factors that would put the earning of profits at risk, steps need to be taken to minimize the effect of those factors in order to enhance the value of the business.