Last month we looked at valuing a business for potential sale using its most recent balance sheet and noted several good reasons why any prospective buyer might not take even an accurate and up-to-date balance sheet at face value. In particular, that the figures are at historic cost, and that there may be potential liabilities that are difficult to quantify and show.
But if you can’t rely on the balance sheet to show the current value of a business, what’s the alternative? One obvious answer is the Profit and Loss account, and many business owners instinctively assume that they would want several years’ worth of profit as the price of selling up.
But let’s remind ourselves that the concept of profit and loss is a little less rigid or mathematical than often imagined. Give several years of your raw financial data to 10 different accountants and it’s unlikely that even two of them will produce the same final profit or loss figure. Even though they all work in accordance with GAAP (Generally Accepted Accounting Practice) standards, there is a degree of subjectivity and judgement in real-life accounting which allows different but equally valid outcomes. Forget the simple calculations (using very limited data) which all accountants perform in their professional exams, and which are only supposed to produce one correct answer real life is more complicated. That’s why a potential buyer gives your accounts to their accountant for a critical examination as part of their due diligence investigating a potential purchase.
Quite apart from any possible queries regarding the preparation of your profit/(loss) figures, a prospective buyer won’t look at them in quite the same way that you might ie the bottom line. They would look to see what the underlying profitability has been over the past few years as a guide to what it might be in the future. This is where you might come across the inelegant term EBITDA or some of its close relatives. EBITDA stands for Earnings Before Interest, Taxation, Depreciation and Amortisation and the concept is intended to show recurring profit or loss without including some variables that might not be relevant under different ownership or operation, or at different times.
If things are quite straightforward...
So your potential buyer examines your financial accounts for the past few years. Let’s assume that the accounts are relatively straightforward with no dispute about how accurate the final P&(L) figures are. Start with the bottom line (Profit or Loss) and then add back the costs shown in the accounts for: interest, taxes and depreciation (including any amortisation of intangible fixed assets). You should end up with a rather larger profit than your original bottom line’s results and in some cases magically turn any bottom-line losses into a profit! Even better, at this stage it is also quite common to go a step further and add back all of the directors’ remuneration charged in those same accounting periods, and that can sometimes create really impressive ’profit’ results!
Now while all of this appears to be working in your favour, you might quietly be asking yourself what the logic is here. The essential idea is that if your business was being owned and run by someone else, they might do it under different circumstances or in a different way and hence see a different profit. Even taxation charges could be different under different ownership . As for taking out the directors’ remuneration, a new owner may operate with fewer and/or less expensive directors, or replace them with ’managers’ on a lower salary, or simply choose to pay themselves by dividends rather than salary again producing completely different bottom-line results.
As a would-be seller you’re now looking at the true profit-generating worth of your business. Of course, it’s still possible that even these adjusted figures could show losses or low profits, but at least there’s a basis from which to start haggling.
From the buyer’s perspective these are still historic figures particularly as regards sales. And what if you’ve simply been sweating your assets to produce those profits but those assets are now past their best and will need expensive replacements?
Ultimately the financial value of anything is whatever someone else is willing to pay for it.
It helps to have reliable figures from which to start the haggling process and some experienced accounting advice in the background but after that it’s really down to how good you are at bargaining!