How the Balance Sheet Affects Business Valuation
It is not uncommon when reviewing valuation concepts to be primarily
focused on the earnings side of the equation. After all, earnings (whether
defined as net income, cash flow, etc.) is what an owner of a business
has available to reinvest for growth, improve equity, take bonuses,
etc. But there is more to business valuation than just the income statement.
How about the building the company owns and uses for operations? It
is very possible that the depreciated value of this property on the
books of the company is far less than its fair market value. Will this
“hidden profit” be accounted for in a valuation which is
concentrated on the income statement? Possibly not. In this instance
it is up to the valuator to recognize the possibility of this enhanced
value, and recommend a real estate appraisal be obtained. Under certain
circumstances, the value in excess of the book value of this asset may
need to be separately addressed in the valuation, thereby yielding a
more accurate conclusion as to the value of the business.
Many times when business valuations are prepared, companies are found
with “non-operating assets.” These are assets that are not
necessary to the company’s operations. Examples of non-operating
assets are:
• Cash in excess of reasonable needs
• Long-term investments
• Land purchased for future use or investment
• Cash surrender value of life insurance.
Non-operating assets are company specific. What is a non-operating asset
for one company may be an operating asset for another. Consequently,
careful analysis of the balance sheet must take place to ascertain whether
or not the subject company has this category of assets.
Values of other assets reflected on the balance sheet must also be
considered when determining the fair market value of a business. Accounts
receivable is a good example of an asset that should not be taken at
face value. While many businesses attempt to reflect the correct amount
of this asset on the balance sheet, this asset should be reviewed by
the valuator. The value of accounts receivable at the balance sheet
date should be an estimate of the collectible balances in the accounts.
However, businesses do not always collect what they think they should.
Customers go out of business without paying all their bills, they dispute
balances or return merchandise, or attempt to negotiate different terms
after the sale is made and product is delivered, etc. Consequently,
the valuator should be aware of these possibilities and deal with the
situation accordingly. Many times the valuation is performed several
months after the balance sheet date, and it may be appropriate to analyze
the actual collection history of accounts receivable to determine the
collectible value at the valuation date. Sometimes this increase or
decrease in value can be substantial and have a significant effect on
the company’s value.
Another asset which should be carefully reviewed is inventory. There
are several methods allowable under generally accepted accounting principles
for valuing this asset. However, even when inventory is valued using
an acceptable method of accounting, there can be much room for change
in the value reflected on the balance sheet. The company’s treatment
of obsolete items, slow moving inventory, inventory at satellite locations,
and in-transit items are a few things which should be considered. Also,
how is inventory priced? Are values based on average cost, fifo (first-in,
first-out), lifo (last-in, first-out), or some other method? Depending
on the method used, the value of this asset can vary widely from the
amount reflected on the balance sheet.
Intangible assets of the company are also important to consider. It
is not unusual in today’s high-tech world to find a company with
modest earnings, but owning a technology which has the potential for
incredible success. These assets are generally referred to as Intellectual
Property, and include patents, trademarks and copyrights. When any of
these types of assets exist (whether reflected on the balance sheet
or not), their value must be assessed and can sometimes have a dramatic
impact on the company’s value.
While valuation of a business will generally focus heavily on the income
statement, the balance sheet also plays an important role and each asset
should be addressed for its potential impact on the value of the business.
For more information on business valuation, contact James B. Hankins,
Jr., CPA, CPA/ABV, CVA, BVAL, Shareholder and Member of the Business
Valuation/Litigation Support Group, at 412.281.4323 or at jhankins@alpern.com.
Back
|