the end of Year 5. To calculate the worth of this type of pay- ment, the payment itself is divided by the discount rate. This works out to be a value of $573.50 at the end of Year 5 ($80.29 / 14%). Finally, to obtain the worth of this annuity today, this value must be multiplied by the discount rate factor for Year 5, which results in an ending value for ABC Company today of $297.87.
When today’s ending value for the organization is added to the cumulative value of the cash flows, a total valuation of the operating cash flow potential of the organization can be calculated. In the ABC Company example, this total value is equal to $524.31 ($297.87 + $226.44).4
Summary
The operations value is independent of and does not con- sider how the organization has been financed and whether or not there is any debt. As you may recall, there is no con- sideration of interest expense in any of the calculations above. This is because it is important to always separate out the investment decision (what is the organization as a col- lection of labor and capital capable of doing), versus how you might fund the investment required to put such an organization in place or to buy one which already exists.
Revenue
Revenues are generally the first item on an organization’s profit and loss or income statement. It represents the pri- mary source of money received from customers or members for goods sold or services rendered. It usually is a net num- ber representing the amount received after taking into con- sideration any product returns and allowances for price reductions.
The first key driver of revenue is price. If your organiza- tion engages primarily in providing products, then the prices involved would be on a per unit basis. If, however, it provides services, the prices involved would more likely be related to the hourly billing rate of the people providing the services. An upper limit on price is often perceived to be set by demand, the competition, or the marketplace. In reality, any product or service provided is a combination of not only the basic product or service, but also the quality, fea- tures, and longevity of what is being sold and the delivery schedule, payment terms, and other characteristics of the sales transaction. The real measure of price is the value per- ceived by and delivered to the consumer.
For example, if a personal tax preparation service offered to review your taxes and save you $3,000 on your tax bill legally, all for $1,000, you would likely take them up on their offer. Logically, you should not care whether the billing rate (price) of the preparer is $1,000 per hour (repre- senting one hour of work) or $100 per hour (representing 10 hours of work). Conversely, some people who do not want a product at any price (e.g., you may not be able to give a free candy bar to some people), will not be swayed by an otherwise low price. Therefore, in the area of the price
driver, there is often more flexibility than meets the eye in making decisions to increase price and cash flow and orga- nization value.
The other key driver of revenue is volume. The more goods you provide at a given price, the higher the revenues are going to be. The more hours your staff is billable in a service business, the higher the revenues will be. Decisions which add a second sale per sales call or result in a service provider selling additional work to the same customer rep- resent examples of how to improve revenues and value using the volume driver.
Operating Profit Margin
The operating profit margin is the percentage of revenues remaining after operating costs for the organization have been accounted for. The major elements of operating costs in most organizations consist of the cost of goods sold or services provided, depreciation expense, and selling and general expenses.
For a typical manufacturing organization, the cost of goods sold represents all the costs incurred in the factory and is usually the largest cost item. Its key drivers generally include raw material, labor, energy, and factory overhead.
The key driver for service organizations is generally labor (i.e., the assets go home at night).
The importance of depreciation expense depends on the size and acquisition time frame of the fixed assets employed by the organization. For the purpose of organization valua- tion, the amount set aside for depreciation is assumed to be spent replacing the assets in question and, accordingly, does not drive cash flow or value at all.
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The key drivers of selling expenses include sales force salaries/commissions, advertising/promotion, and travel/
entertainment. For some organizations, the decisions made regarding product/service distribution and logistics can be a major area in which to improve cash flows and value as well.
The key driver for general expenses is administrative efficiency. However, organizations with large research and development staffs have opportunities for value-enhancing decisions in this area. The main point to remember is that, in cost-centered operations, the organization can only reduce negative cash flow so much without hampering the overall performance of the organization. Accordingly, a global view is important here. Also, some creative organiza- tions, when thinking wisely about cash flow, have actually turned cost centers into profit centers by selling services they otherwise normally perform for their own organization to other organizations as well.
Taxes
When taxes are considered, it is the cash impact of taxes which is important to organization value. Certain decisions regarding depreciation and accounting for acquisitions tend to overstate reported earnings but adversely affect true cash flow.
It generally is a smarter move to maximize the cash flow from tax decisions rather than be overly concerned with what is reported to the public, banks, investors, or other lenders.5
Fixed Capital Investment
The key drivers of fixed capital investment, again, depend to a great extent on the nature of the organization. For low
fixed capital organizations, this item is often considered a secondary driver. However, when safety requirements, machinery additions and replacements, environmental restrictions, and capacity expansion options loom large rel- ative to available cash flow, some or all of these items might be considered key drivers of value.
Working Capital Investment
The three key components of working capital are accounts receivable, inventory, and accounts payable. Each of these, for all organizations, is a key driver. Decisions relating to how much credit to extend to customers, when to pay receivables, how quickly to turn or mark down inventory, and how much interest to charge on delinquent accounts are all factors that affect the level of working capital investment required for a given level of operations and, in turn, affect the overall cash flow and value of the organi- zation.
Summary
Once you have incorporated the key drivers into a simple spreadsheet economic model of your organization, you can easily ascertain which ones are most important to cash flow.
By changing a key driver assumption, you can test the sensi- tivity of the result to the degree of change in the key driver.
Becoming familiar with which key drivers have the largest impact on cash flow is the first step in focusing your deci- sion making on those operations of the organization which are the most important to enhancing its value.
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