Bookkeeping in practice - business valuations

As part of our 'Bookkeeping in Practice' series, ICB's Head of Learning Peter Stewart shares guidance on how bookkeepers can value a business.

Whilst the task of valuing a business is not something we expect bookkeepers to be doing in the usual course of business, it is something that clients may discuss with you and it’s, therefore, useful to have some insight that you can share.

Let’s start with what’s possibly the biggest misconception made by people who have a dangerously small amount of understanding of financial statements.

Here is the most recent balance sheet of a business whose owners have been approached by a competitor with a proposal to merge. The owners, therefore, want to understand what the value of their business is.

The question here is, “Why is the value of the business not £570,000?”

There are two ways to approach this question. Firstly, understanding what has gone into those accounts and how accounting principles have, to a large extent, dictated what the figures show. The other approach is to think about what “value” actually means.

What’s in the accounts?

Without explaining each line, consider the principles of Historic Cost Accounting and the concept of Going Concern.

The fixed asset figure of £550,000 reflects what the fixed assets cost however long ago they were acquired and then accumulated depreciation using a policy and depreciation rate that this business chose to apply.

Almost certainly, this is not the value that the business would get were it to put those assets on the market one-by-one… not that that is the only way to measure “value”.

Likewise with debtors. We have a value of £200,000 in the balance sheet representing the total of invoices that have been issued, adjusted by a subjective consideration for bad and doubtful debts. If the business were to spend the next month or two doing nothing other than trying to collect debts, the chances are that the cash recovered would be short of £200,000.

In short, even if someone were buying the business simply to cash in on the assets and settle the liabilities, the net asset value of £570,000 would not be the amount they would be willing to pay.

Going Concern

When a business is being acquired, it is typically bought as a going concern. What is being bought is not a set of assets but the ability to generate cashflows in the future. This ability is not identified in the financial statements, although they do show how the business has generated profits and cash in the past. However, we all know that past performance is not a reliable indicator of future outcomes.

Factors beyond the business’s financial statements that should be considered include (but are not limited to):

• Intangible assets that are not valued in the balance sheet. We might think of this as “goodwill”. The good name of the business and brand recognition has no historic cost but could be a significant factor in generating fresh income or repeat business from loyal customers.
• Economies of scale. In the hands of a new owner, the business may have access to better deals from suppliers and may be able to make other operational savings, resulting in higher profits from, effectively, the same business.
• Management and staff of the business and their reputation for innovation, great customer service, effective selling techniques and so on. If the staff are reckoned to be a significant factor in the business’s success, you would have to consider whether they are loyal to the business and will be retained if ownership changes.
• The market in which the business operates. There are so many factors we need to understand about competition, developments in technology, changes in legislation and regulation that have the potential to affect the future success of the business. None of these is reflected in the financial statements that you, as the bookkeeper, have prepared.

This article just scratches the surface business valuation.

A ‘value’ is very much a unique amount. You must realise that it is different to a price. For instance, I see a Rolex watch selling for £7,000. Even if I had that money to spend, I don’t value a watch that highly. I have ways of telling the time (my phone, computer, clocks around the house and in the car) and don’t feel the need to wear jewellery. Others, though, would like to have that watch and will value it at £7,000, perhaps more.

Similarly, no two buyers will place the same value on a business and, likewise, someone selling a business will have a different view of its value to whoever is trying to buy it. The seller will want to realise as much value as possible whilst the buyer will want to pay as little as they can get away with.

In summary, valuation of a business has no correct “answer” but an awful lot of factors to consider, discuss and negotiate.