There are numerous components that go into valuing the assets of an active business. In simplified terms, those components can be characterized as the value of normalized discretionary cash flow plus redundant assets. In this article, we will be discussing two of the more common redundant assets that business owners frequently do not realize exist within their organization.
Redundant assets are defined as assets that are not necessary to the ongoing operations of the business enterprise. These can be tangible or physical assets the business owns that would not impact the business’ operating cycle if extracted. The identification of these assets can often appear to be straightforward. For example, a business may have accumulated excess profits and invested those funds in a stock portfolio. However, there are other redundant assets that are overlooked or not apparent on the face of the balance sheet.
Excess working capital
Working capital is generally defined as operating assets (accounts receivable, inventory, prepaid expenses, etc.) less operating liabilities (accounts payable, wages payable, GST and income taxes payable, etc.). In too many cases, business owners become complacent about the managing of their working capital. The result may leave the business with excess receivables, inventory on hand or an accumulation of cash. By reviewing the business’ own pattern of working capital usage, as well as industry practice, additional “hidden” value contained in the regular operating assets can be quantified. This would ensure the value conclusion has captured the fair market value of the assets appropriately.
The working capital position at the valuation date is not the only consideration. Many businesses have an operating cycle that require them to have more working capital on hand at various times. The valuation may be on a date when the business appears to have excess working capital. On a closer review or understanding of the business background, it might be observed that the business requires a larger amount of working capital to meet its needs through a start-up period each operating cycle.
A valuator must not hastily apply industry ratios when establishing required working capital. A business may have unique terms and conditions to the payment of their operating liabilities that allow them to have less operating assets on hand to meet their obligations. Effectively valuing the working capital position of an entity – to determine any hidden redundant asset value – requires a strong understanding of the business, industry and operating cycle.
There are the obvious instances of real property being identified as a redundant asset. Such is the case where a business uses excess retained profits that are not required in the day-to-day operations to invest in secondary properties (to earn rental income, for example).
What is often mistaken for an operating asset is the premises the business operates from when owned. Businesses will frequently acquire the property where they operate, in order to retain more value in their business, rather than pay rent to an independent third party. Inherently, that is an investment, even though it is being used in the operations of the business.
In these cases, a valuator needs to gain an understanding of the characteristics and use of the real property. It is common for a larger than necessary property to be acquired either for investment or possible expansion. This will result in the excess space of the property being rented out or remaining underutilized.
Determining the normalized discretionary cash flow in businesses where the operating premises are owned entails adjusting cash flows for the amount that would be paid if the operating space was rented from an independent third party. This adjustment requires knowing the actual amount of space necessary to operate and what the commercial rental rates are in the local market. Other factors, including whether the market rates are based on a “triple net” or “gross” lease, need to be considered to ensure the cash flows are not over or underestimated.
Even though a business may own a building and use it in active operations, this does not mean it is required to operate when renting is a viable option. Businesses with real property should engage the services of a professional real estate appraiser to provide a report on the fair market value of the property. This report is then used by a Chartered Business Valuator in determining the value of this redundant asset to a business.
Valuation of redundant assets
As redundant assets can be extracted without impacting the ongoing operations of the business, the value of any redundant asset to a business is the net realizable value. Net realizable value is the net proceeds from the sale of an asset after deducting costs of disposition, including income taxes. The underlying disposition costs and corporate taxes are often discounted due to uncertainty regarding if and when these assets would be disposed.
In summary, it is a foundational element to have the appropriate depth of knowledge and understanding of the business. This will allow one to effectively identify whether assets should “be or not be” part of the operations and determine the value of any redundant assets to the business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.