Business valuations are about measuring risk and reward – the reward being the amount of cash a business generates for its owners in the future, and the risk being the uncertainty of exactly how much, and how fast.
A business could make more or less than you think, and it could happen faster or take longer than anticipated. A business valuation considers how buyers and sellers might look at those two issues to come to an agreement about a single present value to exchange for all of those uncertain future amounts.
While the accounting balance sheet tells you how much a business spent for assets bought in the past, it doesn’t consider what happens when you combine these assets with the efforts of employees.
When a business combines the assets it bought with the efforts of employees, it creates new assets. The balance sheet tallies the cost of the assets a business buys, or the amount of its investment, but you need a valuation to tell you about the assets a business makes, which is its return on investment.
Omitting this information from the balance sheet is significant because it represents the majority of the value of most operating companies.
For an individual considering selling or buying a business, it’s critical to know the total value of all of a business’ assets, not just the ones on the balance sheet.
Generally, these newly created assets are broadly referred to as goodwill. If you’re buying or selling a business, you want to know the total amount of current goodwill which is likely a lot different from the amount of goodwill that’s on the seller’s balance sheet.
Measuring the value of goodwill, which includes assets like brands, customer relationships and proprietary technology, requires making projections about how the business will do in the future – information you cannot get from the historical financial statements.
The benefit to management is that making these projections forces them to consider the value drivers for these assets.
A business valuation is an extensive undertaking, but it provides critical information excluded in standard accounting records. If you have any questions about conducting a business valuation, contact us today.
Categories: Audit & Accounting, Valuation
