Welcome to the inaugural issue of Value Strategies - a quarterly newsletter dedicated to helping business owners and executives in measuring, enhancing and realizing shareholder value for their company.

Value Enhancement is a publication of Veracap Corporate Finance Limited, a firm specializing in acquisitions, divestitures, management buyouts, family business succession, private equity financing and corporate growth strategies. To us, value enhancement represents more than what a business is worth at a point in time. It also encompasses proactive strategies to maximize business value over the duration of ownership, and to achieve the monetary and non-monetary objectives of the stakeholders involved. Veracap has developed proprietary frame­ works and processes that help in realizing these goals.

Cash flow

Cash flow, rather than accounting earnings, is a key element to shareholder value. However, it is important to understand what is meant by cash flow. Too often, the focus is on measures such as EBITDA (earnings before interest, taxes, depreciation and amortization). But this only tells half the story. The best measure of cash flow is 'discretionary cash flow', being the cash that can be withdrawn from a company without impairing its operations or growth prospects. Discretionary cash flow takes into account all of the cash requirements of a business, including income taxes, capital expenditures, and working capital to support growth. The calculation of discretionary cash flow is illustrated in Exhibit 1 below.

Note that discretionary cash flow is calculated before interest expense, given that financing is determined sepa- rately from operations. In addition, discretionary cash flow should be normalized to eliminate unusual or nonrecurring items, as well as to reflect payments to related parties at market rates.

Discretionary cash flow can be increased by increasing revenues, controlling operating costs, or better manag- ing other cash outflows such as capital expenditures, working capital and income taxes. For example, by imple- menting better inventory management practices, a company can generate immediate discretionary cash flow through a reduction in inventory levels. In addition, as the company grows, the incremental amounts it must invest in inventories should also be reduced, thereby further increasing shareholder value.

Veracap Corporate Finance Limited Experts In ValueTM

Debt Utilization

One of the keys to managing risk and growth potential lies in understanding a company's customer base. Business owners and executives need to know who their customers are, why those customers are buying from their company, the customer's decision process and decision criteria. Shareholder value is created where a company develops a diversified base of repeat customers, as this serves to improve revenue stability and reduce risk.

Dividing discretionary cash flow by the capitalization rate derives the enterprise value of the company, being the total value of its operations, which is independent of how the company is financed. Interest bearing debts (such as bank operating loans, term loans and capital lease obligations) are deducted from enterprise value to derive shareholder value, i.e. the portion of the company's total value that accrues to its owners.

However, this does not mean that debt financing should be avoided as a means to increase shareholder value. Rather, shareholder value is created where the incremental benefits from borrowing (e.g. to finance an expansion project) outweigh the cost of capital. Debt financing can be attractive because interest payments are tax-deductible. In addition, many business owners have most of their economic worth tied up in their company. By substituting equity for a modest amount of debt, shareholder value can be increased because the return on the remaining equity will be higher. This strategy also allows business owners to diversify their holdings and protect themselves (somewhat) against a severe downturn in their business.

Debt Utilization One of the keys to managing risk and growth potential lies in understanding a company's customer base. Busi- ness owners and executives need to know who their customers are, why those customers are buying from their company, the customer's decision process and decision criteria. Shareholder value is created where a company develops a diversified base of repeat customers, as this serves to improve revenue stability and reduce risk.

Veracap Corporate Finance Limited Experts In ValueTM