The balance sheet is one of the most important financial documents used for valuation purposes. Other documents include the income statement, the statement of cash flow, and shareholders’ equity.
How Does the Balance Sheet Help in the Business Valuation Process?
- It provides details of the company’s financial position on a particular date.
- It gives information on the company’s total assets and liabilities.
- Potential investors, lenders, taxing authorities, and suppliers use a balance sheet, along with other vital documents, to gauge a company’s financial condition.
- Valuation experts assess the balance sheet as a part of the business valuation process.
Critical Components of a Balance Sheet
A balance sheet has three key components: assets, liabilities, and stockholder’s equity.
Assets. The balance sheet reflects the company’s tangible assets (e.g., equipment, inventory, real estate) and intangible assets (e.g., intellectual property). It includes cash, accounts receivable, and any accumulated depreciation related to equipment and other tangible assets. The sum of these assets forms the total assets on the balance sheet.
Liabilities. Liabilities refer to the company’s pay, such as accounts payable (i.e., bills), payroll liabilities, lines of credit, credit cards, loans, and other debt-related items. The company may also list the remaining debt under penalties of an asset it used to have but no longer owns. The sum of liabilities shows up as the firm’s total liabilities on the balance sheet.
Stockholder’s equity. The last component of the balance sheet is stockholder’s equity, shareholder equity, or book value. It is calculated as the difference between total assets minus total liabilities.
Book Value = Total Assets – Total Liabilities.
For example, if a company’s total assets are worth $5,000,000 and its total liabilities amount to $1,500,000, then its book value is $3,500,000 ($5,000,000-$1,500,000).
Book value also refers to the amount on the balance sheet that represents share capital plus retained earnings.
Book Value = Share Capital + Retained Earnings.
Retained earnings include business profits set aside for investment back into the company and not distributing dividends to shareholders. They can be used for asset purchases, funding working capital, debt servicing, etc. To calculate retained earnings, add net income to the previous period’s retained earnings and deduct dividend payouts.
Book Value Method Use and Limitations
Book value or shareholder equity is:
- the capital the owner may use for dividends or re-invest back into the company, or
- the out-of-pocket capital that the owners may have to invest in the case of negative book value.
The book value is considered the base value if the company decides to cease operation and liquidate its assets. However, for a going concern, book value neither considers the business’ future revenues or expenses nor takes the market into account. In the real world, people may be willing to pay more or less than the book value for a company.
In the event of liquidation, all liabilities and interest-bearing debts are paid before the shareholders receive their portion of the payout. So, bondholders are paid first; they are interested in the available amount of equity to determine overall solvency. However, stockholders worry about liabilities as well as shareholder equity.
Balance Sheet Items that Impact Business Value
Investment in Capital Assets or Capital Expenditures
Depending on the nature of the enterprise, a growing company typically has more capital expenditures than average depreciation expenses. When a business with an aggressive growth plan does not increase capital expenditures accordingly, it is not creating growth, only hoping for it.
Capital expenditures impact value in two ways:
- When there are consistent, ongoing maintenance capital expenditures that represent a significant component of otherwise “discretionary” cash flow, it indicates a capital-intensive business or a business having old assets that need replacing. Here, valuation experts need to adjust the cash flows to show the ongoing nature of these cash outflows. It reduces the company’s value against other firms that are not capital intensive or have new assets, which postpone the need for additional investment.
- When a company’s capital expenditures are pretty inconsistent and result in growth, the organization builds capacity. So, when valuation experts consider capital expenditures in forecasting future cash flows, they reflect a growth profile due to the consistent investment in additional capacity.
Buyers are ultimately looking for the metric called free cash flow in your business. It measures the amount of cash a company generates after accounting for capital expenditures and other essential things, which can be used for dividends, expansion, and debt reduction. So, to value a business, free cash flow is as important a measure as is the company’s profitability. Business owners need to know the difference between the capital expenditure required to maintain current profitability and the investment in capital assets for any projected growth.
Level of Non-Operating Assets
Assets showing on the balance sheet but not needed for the ongoing business operations are non-operating assets. These may include cash, golf course memberships, vacation homes, land, and buildings from which the business operates, marketable securities held in a brokerage account, surrender value of insurance policies, etc.
For instance, a company’s balance sheet shows $500,000 cash and equivalents. The non-current assets include a vacation home, recently appraised at $700,000. When assessing the business value concerning working capital assessment, valuation experts consider these items as non-operating assets.
The working capital calculation is a significant discussion point between sellers and buyers during M&A deals. Sellers want to leave as little working capital in the company as possible to take the excess cash. Buyers want to get as much working capital as they can to use for business operations.
Commercial Real Estate
Many businesses operate from the commercial real estate owned by the business owners. Business owners should know both the value of their property and how it impacts the value of their business. Business owners need to value the company and the real estate as separate assets.
The Use of Balance Sheet in the Due Diligence Process
When buyers begin the due diligence process, the balance sheet is one of the most common financial documents they assess. The due diligence involves digging into the details of the selling company’s financial statements, customer agreements, etc., to ensure that the price paid for a business is based on accurate information.
The numbers on the balance sheet tell a story. Valuation experts decipher the story to calculate free cash flow and working capital, then determine the accurate value after making necessary adjustments. The items on the balance sheet do impact value, although valuation experts also assess other essential documents to arrive at their conclusions.