Finance & Grow Your New Business. Angie Mohr
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owners’ pocket after all of the business expenses are paid. Note that we are talking about all the expenses, which includes remuneration for all work done in the business. In this scenario, you will be paid a management salary of $48,000 in years one and two, $59,000 in years three and four, and $63,000 in year five.
If, however, your cash flow projections don’t allow for you to be paid for your labor, calculating a return on investment is rather meaningless. It means that, not only are you investing money, you are investing your labor for free (this is known as “sweat equity”). In this scenario, however, you are being paid for your efforts and therefore can look at how much you’re getting for your $50,000 investment.
The net cash available for distribution to the owners looks like this:
| On start up | ($18,860) |
| Year 1 | ( 17,060) |
| Year 2 | ( 7,250) |
| Year 3 | 9,650 |
| (YEA!! Positive cash flow!) | |
| Year 4 | 25,590 |
| Year 5 | 46,390 |
We also know from the above discussion that a dollar received or spent tomorrow is worth less than a dollar received or spent today. This means that we will want to discount this stream of cash flows back to today, to the present value of the dollar, to make sure we are comparing apples to apples, so to speak. The first thing that we need to do is to find a meaningful interest rate at which to discount the cash flows. After speaking with your banker, you know that you can borrow from the bank at 10 percent, so we will use this rate to do our discounting.
Let’s follow through the example, using a portion of the present value table reproduced below:
| Period | 10% |
| 1 | 0.9091 |
| 2 | 0.8264 |
| 3 | 0.7513 |
| 4 | 0.6830 |
| 5 | 0.6209 |
This table tells us, for example, that if we are going to receive a dollar a year from now, it is only really worth 90.91¢ today. You can see that, as we go farther into the future, the worth of that same dollar becomes less and less. We have to bring all of our cash flows back to a common point: today. Sample 2 has completed the calculations.
Sample 2: Discounted Cash Flows for a Start-Up Business
This tells us that, over five years, the company will generate $13,171 in net positive discounted cash flow. We also know that you will have to invest $50,000 to get that cash flow. The calculation for your average annualized return on investment (ROI) is:
ROI = net cash flow ÷ investment ÷ # years
Therefore, your roi in this scenario will be:
ROI = 13,171 ÷ 50,000 ÷ 5 = 5.27%
Your average annual return on your initial investment is 5.27 percent. This calculation is helpful in deciding whether to invest the money in this business or another business or another type of investment altogether. It is important to realize, however, that after year five, the cash flow is in permanently better position as the company matures. Therefore, by the time year six rolls around, the business will be generating in excess of $46,000 in net profit; a much higher return for the initial investment. Return on investment analysis will change depending on the time frame used.
Considering a business purchase
Let’s look at the cash flows for the projected business purchase and see how they compare to the start-up business using the same analysis.
The purchase price for the business is $225,000. The bank is willing to lend $175,000 at 10 percent and you will have to invest $50,000 of your own money. This company has been in business for many years and therefore has mature cash flows already, similar to those in your projections for year five of the start-up company. The cash flow projections are shown in Sample 3.
Sample 3: Cash Flow Projection for a Business Purchase
There are a few important items to note here:
• The purchase of capital equipment is more regular than in the build scenario and of similar amounts from year to year. The company already owns its equipment (that’s part of what you’re buying) but some will need to be replaced every year as it wears out or becomes obsolete.
• The revenues are growing by a lesser percentage than with the start-up company. This company already has a mature market and grows at a slower pace than a business in its infancy.
• The net cash flow of the business operations is much higher than that of the start-up, but we have to figure in the payments of principal and interest on the bank loan before we can calculate the return on the owner’s investment.
• In both scenarios (start-up and purchase), the management salary is the same and therefore does not become a factor in the decision-making process. However, if the salaries in each were different, you would have to “normalize” them. This means that you would have to recast the numbers of one or the other (or both!) projections to reflect the amount of management salary that you intend to take from the business, otherwise you are not comparing apples to apples.
Take a look at the discounted cash flows for the purchased business in Sample 4.
Sample 4: Discounted Cash Flows for a Business Purchase
This tells us that the total discounted cash flows of $24,192 are higher than in the start-up scenario ($13,171). However, if the amount of the original investment had been more in the purchase scenario, this still may not be the better option. The only way to accurately compare between the two is to complete the roi calculation. In the purchase scenario, the calculation works out to: