Should you use accrual or cash basis accounting for business valuation?
Private companies have a choice of doing their accounting on the cash or accrual basis. You may wonder: is either choice more suitable when it comes to valuing the company?
Matching income and expenses
The question you face in a typical business appraisal is this. Are all business income and expenses identified and matched correctly?
Suppose that a sales commission is due to be paid for a revenue generated in a given period. If you don’t show both the sales and commissions, you may overstate the business income. In this sense, accruing the necessary expense along with the sales generated is the proper way to show how the company creates and uses its funds.
Business value is all about earnings and risk. When you value a company you wear the hat of an owner. So you ask the important question. How much money can I take out of the business without starving it of the funds needed to keep the operation running?
Showing the money – business earnings measures used in business valuation
That’s why cash flow based earnings measures, such as the net cash flow or seller’s discretionary cash flow, are more useful for business valuation than the typical accounting figures of net income, EBITDA or EBIT. Cash flows show how the business sources and uses its money. And this calls for matching the income and expenses in actual amounts and timing.
So the accrual financial statements are a good start. In addition, you would need to check into how the business uses its short and long-term capital. Is it necessary to build up inventory to meet increasing demand for products? Does the company need to set aside money to buy new machinery or fix some existing equipment?
The investments you must make to keep the business running
These capital expenditures do not show up on the company’s income statement. However, such capital needs are quite real and can seriously change the cash flow picture. If the company needs to divert a sizable chunk of cash toward buying new technology, the money is not available for distribution to the owners. Same goes for expansion capital needed to grow the business. Such capital drains can change your business value quite a bit.
Incidentally, underestimating the capital expenditures is one of the most common mistakes made by business buyers. Take a look at how important it is to account for all the elements in a business purchase to make it a success.