By Shawn Hyde, International Society of Business Appraisers (ISBA) –
Every so often I come across a valuation report where the value of a shareholder’s interest in the company has been based on the Book Value of the business. Book Value is likely used because it is easy. It is updated every time the financial statements are updated, so it is always current. But in this article, I want to explore Book Value in more detail.
Book Value is tracked on a balance sheet by an enterprise’s accountants. The current asset section is fairly easy. Cash is equal to the amount of cash owned by the business, and the Book Value of cash is always equal to its Fair Market Value.
Accounts receivable are listed at the amount of cash the company is owed for services or products rendered, usually less an estimated amount for uncollectible accounts. Most of the time this asset’s Book Value is at least close to Fair Market Value.
But inventory can be a tricky one. I have seen several small businesses purposefully understate the actual inventory on their books, yet then struggle to prove what they actually have when the time comes to sell the business. Alternatively, when the time comes to buy out a partner, or if there is a marital dissolution lawsuit, that same business may attempt to maintain the fiction of the smaller level of inventory. There are also situations where the company has held onto certain inventory assets for so long that they have become obsolete. I have also seen a situation where the business purchased a whole year’s worth of raw stock at a time, so they actually had excess inventory on hand for most of the year. The point here is that most of the time, the Book Value of inventory is rarely equal to its Fair Market Value.
A company’s fixed assets are all listed at the original cost of obtaining the assets, less accumulated depreciation over the years since an asset was acquired. But what happens if another asset was traded in as part of the cost to purchase an item? The trade-in value of that second asset is not associated with the cost on the balance sheet, understating even the Book Value of that asset. Some assets can be fully depreciated, meaning their Book Value is zero. Does that mean the asset has no Fair Market Value? Not necessarily. If it’s a piece of equipment that is still used in the operations of the company, then it does have some contributory value, but the business’ Book Value will not capture it.
Some businesses list other assets on their balance sheets that contribute towards the Book Value of the operation, such as deposits, employee advances, prepaid expenses, leasehold improvements, and sometimes shareholder loans. If the business were to be sold, would all of those assets transfer ownership to the new buyer? Not likely. Do all of those assets contribute to a business’ Fair Market Value?
On the other half of the balance sheet, the company tracks its debts and liabilities. If the Business owes money to a shareholder, and yet the business has NOT made any payments on that loan for the past several years, is it really a loan or should it be treated as an equity infusion? That loan counts as a negative under Book Value, but under Fair Market Value it could represent an increase in overall value.
Book Value is a very easy number to find, but it may not always be the best number to base a transaction on, either for a third party buying in or to buy out a current partner.
If you would like to learn how to convert the reported Book Value of your clients’ businesses into a Fair Market Value, or you would like to pursue your own Business Certified Appraiser (BCA) certification, please contact me at shyde@intlBCA.com. The International Society of Business Appraisers (ISBA) can teach you what you need to know to get started.
About the Author: Shawn Hyde, CBA, CVA, CMEA, has over 20 years of valuation and appraisal experience in numerous industries. He currently serves as the executive director of the International Society of Business Appraisers (ISBA), www.intlBCA.com. He is a Certified Business Appraiser, Certified Valuation Analyst and a Certified Machinery & Equipment Appraiser. He has written and taught courses for the Institute of Business Appraisers (IBA), the National Association of Certified Valuators and Analysts (NACVA), and the International Society of Business Appraisers (ISBA). He has served on the IBA’s Education Board and the IBA’s Board of Governors, and he is a past Editor in Chief of the IBA’s professional journal, “Business Appraisal Practice.”