“The greater our knowledge increases, the greater our ignorance unfolds” (John F. Kennedy)
The balance sheet is the most important financial statement. It sets out what a business owns (assets) and where the funds came from (liabilities). A business basically has two options on where to source funds. It can either use funds from investors (equity) or it can take out loans (borrowings). Gearing expresses the relationship between equity and borrowings. A business with a high proportion of funds sourced from borrowing is classed as high-geared and a business with relatively low borrowing is classed as low-geared.
Decisions about gearing levels need to be made when you are considering raising finance for your business or when you are considering making an investment. As an investor, high-geared businesses represent a higher level of risk with the prospect of a higher return.
A recent example of this is the Ashtead Group PLC, http://www.ashteadgroup.co.uk/. One of the star performers on the London Stock Exchange in 2004, Ashtead increased its share price from 15p in January 2004 to 85p in December 2004 an increase of 177%. Over this period the Group increased profit, but more significantly the high level of gearing of the company, in excess of 200% meant that the increase in profits were available to be shared among a relatively small number of shareholders
Ultimately the value of a business is decided by what someone is willing to pay for it and when an offer is made a formal valuation process will be followed. However small business owners, for whom the business represents their main source of wealth, will often wish to have a quick "rule of thumb" guide to the value. In situations like this a quick valuation can be arrived at by looking at past profits as a guide to likely future profits which can then be used as the basis for a valuation.
For example, suppose a company developing and installing supply chain software made a profit of £100,000 in the last financial year and that this profit was after a normal charge for owner's remuneration with no bonus. To value future profits, the most recent profit must be multiplied by an earnings multiple which will be specific to the industry sector and which can be obtained or deduced from data available in the Financial Times. On the assumption that the earnings multiple in this sector varies between 5 and 10 and that the owners are optimistic about future products, a multiple of 6 might be appropriate. Let's assume that the business also has loans outstanding of £200,000.
Putting this together would give a “rule of thumb” valuation of:
| Profit | £100,000 |
| Multiple | 6 |
| Future Profits | £600,000 |
| Less: Borrowings | £200,000 |
| Value of Business | £400,000 |
Profit is not the same as cash flow and a business can be profitable and at the same time not generating cash.
There are a number of reasons for this. One of the most important is that in calculating a profit figure, accountants have to make a number of subjective judgements and estimates which relate to matching income to expenditure, whereas cash flow depends solely on when cash is received and paid.
The survival of a business, especially in the early stages may depend on the management of cash flow. This requires a sound distinction to be made between profits and cash flow and effective application of this knowledge.
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