Today we are going to look at the link between return on equity (ROE), free cash flow and the cost of capital.

This matters because free cash flow and the cost of capital are the main drivers of the value of your business.

The reason many private business owners fail to grow their companies is because they don’t optimise both these value drivers.

Business value is more than just growing net profit.

In this edition, we will look at:

• ROE and free cash flow.

• The cost of capital.

ROE and free cash flow

Let’s look at the link between ROE and free cash flow. The formula for Free Cash Flow to the Firm (FCFF) is:

FCFF = net profit after tax + [interest paid x (1 - Tax rate)] + non-cash charges - working capital changes - capital expenditures

Recently, we talked about optimising your income statement by growing sales, controlling cost-of-sales and minimising expenses. When you do these things, you automatically increase net profit after tax.

We also talked about optimising your balance sheet by minimising net working capital and fixed asset purchases. In addition, keeping your fixed assets to a minimum will also minimise non-cash charges like depreciation.

From the diagram below, if you put all of these items together, the effect is an increase in ROE and free cash flow. In other words, by improving ROE, you have automatically improved free cash flow.

The cost of capital

The second factor that affects the value of a business is the cost of capital. This is usually calculated as a combination of the cost of equity and the cost of debt.

As we have previously mentioned, the cost of debt is generally lower than the cost of equity. Therefore, the temptation is to increase the use of debt. But debt should not be abused, because the more debt you have, the greater the risk of bankruptcy. However, the use of some debt is acceptable and helps to increase the value of the company by reducing the cost of capital.

In the discussion on optimising the balance sheet, we suggested that the appropriate use of debt is for the purchase of productive assets. The lower cost of debt will reduce the cost the capital. This in turn will increase the value of the company.

Conclusion

As you can see from the diagram, when used smartly, ROE helps you to target and improve all the factors in a business that increase value.

As an investor, I have not run into any small businesses where the owners were using a system grounded in finance theory to grow the value of their business. Normally this where buyers poke holes in the asking price. They offer less because the business is not optimised. If a business was optimised using ROE, an investor would have no choice but to offer more because the cash flow benefits would be indisputable.

Give it a try in your business. It benefits the business even if you don’t plan to sell, because you will see an increase in cash flow.

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