In my opinion, Seinfeld was one of the best true-to-life sitcoms in television history because the storylines drew from actual events in the writers’ lives. One of those recurring storylines was the spirited discussions surrounding Cosmo Kramer’s never-ending business schemes; in particular, in the episode “The Voice” –
Kramer (reading the newspaper): Look at this – they are renovating the Cloud Club.
Jerry: Oh, that restaurant on top of the Chrysler building? Yeah, that is a good idea.
Kramer: Of course it’s a good idea, it’s my idea. I conceived this whole project two years ago!
Jerry: Which part? The renovating the restaurant you don’t own, part or spending the two hundred million you don’t have, part?
While Kramer occasionally thought of viable business ideas, he failed to consider the amount of capital expenditure or working capital necessary to fund these operations. When valuing a business, it is important not to overlook these critical factors. Working capital and capital expenditures can represent a significant amount of cash outflows for a business and drastically impact its value.
When a company creates a financial forecast, the management team may project future growth in income and expenses based on the company’s historical activity. This is a logical way to estimate future earnings. However, when using these projections in a valuation analysis, it is important to consider the amount of capital expenditures and working capital required to support this growth.
For example, a manufacturing company often needs to pay for materials, labor and other costs, long before a product is shipped and money collected from the customer. Let’s say a manufacturer of custom engineered products, generating annual sales of $50 million and cash flow of $1 million, requires working capital of approximately 20% of sales to fund projects before collecting cash from customers. If the company expects to grow 4% in the next year, an additional $400,000 of working capital will be required. In this simple example, $400,000 represents 40% of the company’s prior year cash flows. This is significant in the income approach to valuation, which is predicated on the amount of cash available to investors. In order to support the projected growth of the company, 40% of the cash flows must be reinvested and will not be available for distribution to the shareholders, which has a significant impact on the company’s value.
The same concept applies for capital expenditures. When relying on financial projections, a valuation analyst should be conscious of the capital expenditures needed to support the company’s growth. Historical financial statements can help determine recurring capital expenditures to keep equipment and facilities current, but an analyst should also consider larger expenditures that may not have been necessary in the past.
- Does the company’s growth require expansion to a larger facility?
- Is new technology required to produce the company’s products or services?
- Does the company plan to create a new product or service that requires additional equipment?
Any of these scenarios could create a need for significant capital expenditures in order to support the projected growth in revenues. Similar to additional working capital requirements, capital expenditures will reduce the amount of cash flows available for distribution to investors and impact the value of a company.The concepts of additional working capital and required capital expenditures seem simplistic, but these items can be easily overlooked because they are not expenses recorded in the income statement.
Unfortunately, Kramer didn’t seek the services of a business advisory firm to start his own restaurant, chicken farm or Cuban cigar production, but the professionals at Skoda Minotti can help you with your business venture.
From the incubation phase through succession planning, our experts will help you prepare for the appropriate capital expenditures and working capital requirements that will not only help you start a business, but keep you in business as well.