February 2021

Many businesses have suffered severe disruption during the pandemic although some have benefitted, e.g. those with a strong online offering or those providing essential services. Whilst most businesses hope to recover after the lifting of restrictions, many others will be affected permanently.

Business valuations are often needed in connection with various types of litigation, such as disputes between shareholders or partners, divorce cases and cases involving a lost business opportunity. This newsletter considers the financial data required in valuing businesses with particular regard to those which have sustained “temporary” set-backs compared to those affected permanently.

Overview

In considering whether a business has suffered a temporary set-back or permanent damage, an expert accountant will need to take account of many aspects including an evaluation of the business being able to continue as a going concern if its working capital has been depleted owing to additional debt or non-payment by customers. Future cash flows also need consideration in relation to the repayment of debt and to take account of the loss of business arising from the general downturn in the economy.

Based on the preceding paragraph, it is necessary to consider whether the primary focus of the valuation will be on the capitalised maintainable earnings of the business, on the value of discounted future cash flows, on its net asset base or on the capitalised value of dividends paid by the business. If the business is unlikely to be profitable in the future but has a relatively healthy asset base, it may be more appropriate to consider the net assets rather than its earnings stream. A profitable business sustaining a temporary downturn is more likely to be valued on a going concern basis in comparison to one which has sustained permanent damage and which may need to be valued on a break-up basis.

Information Requirements

Information or issues relating to financial performance may include…

  1. the need to consider the business’s profitability for a number of years prior to the valuation date if the valuation is to be based primarily on maintainable earnings and whether the profit figures need to be weighted to give more importance to the most recent results. This approach is more suitable for a business which has sustained temporary damage to its activities.
  2. management accounts reflecting the business’s most recent performance and any exceptional costs.
  3. the order book and forecasts or business plans prepared as indicators of future performance. Greater weight will need to be given to projections for a business with a permanent decline but also for a business with possible rental savings arising from increased home working or a shift to online retailing.
  4. trends in the turnover of the business and changes in its customer base. Particular account will need to be taken of customers who have ceased to trade or cancelled contracts owing to the pandemic.
  5. the cash flow generated by the business before interest, depreciation and tax. Considering future cash flows will determine whether the business can continue as a going concern. Liquidity is likely to be adversely affected if recent government and bank loans need to be repaid in the foreseeable future.
  6. the “price” to be applied to the annual maintainable earnings of the business, i.e. the amount payable in the market for buying an earnings stream by reference to “price/earnings” ratios applicable to actual transactions or by reference to the average ratio applicable to the relevant industry sector for companies quoted on the Stock Exchange. These ratios are likely to reflect the changing fortunes of specific sectors during the pandemic.

Information or issues relating to the assets and liabilities of the business may include…

  1. the net asset value attributed to the business. This data is vital if a business is unlikely to be profitable in the future or if the value exceeds that attributed to the business based on its future earnings.
  2. the values of any assets such as land and buildings or obsolete stock which need to be revalued to provide a more accurate indication of the net asset value of the business.
  3. contingent liabilities resulting, for example, from claims against the business. There may be a greater prospect of claims if the business is unable to settle its creditors as they fall due.
  4. significant forward commitments such as leases or contractual arrangements.

General information relating to the sector in which the business operates may include…

  1. the extent to which indicators of financial performance are comparable with sector norms.
  2. the extent to which the business relies upon key individuals, customers or suppliers. Business prospects will be damaged if employees have fallen ill or if customers or suppliers have been affected adversely.
  3. the possibility that a buyer would be prepared to pay a “hope value” for a business which will not be profitable in the expectation of being able to improve its profitability.

Conclusions

Given prevailing uncertainties, it is vital to avoid a mechanistic approach to current valuations and to ensure that they are based on the best available information and the most appropriate methodology.

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The information contained in our Newsletters is provided as general information only. It does not constitute professional advice and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. In addition, since the Newsletters were published in recent years, the information contained in them may not be applicable at the current time.