Find out why the assessment of liquidity required for operations is often misunderstood in business valuation.
Find out why the assessment of liquidity required for operations is often misunderstood in business valuation.
The question of whether a company's cash and cash equivalents are necessary for operations or not is usually answered differently in the context of a business valuation than in the context of an annual audit, restructuring, impending insolvency or in comparable circumstances. Auditors in particular regularly act as business valuers, but are also called upon to assess the economic situation of a company. This often leads to the term being misinterpreted in the valuation context. The following article attempts to clarify the term "operational necessity" of a company's liquid assets in the context of business valuation.
Valuers regularly justify the operational necessity of cash and cash equivalents by stating that the cash and cash equivalents on the valuation dates are to be used to finance certain operational measures and are therefore indispensable, i.e. operationally necessary. Here are some examples of cases of "alleged" operational necessity of liquid funds:
• The cash and cash equivalents as at the valuation dates serve to finance an investment project that has already been planned.
• The cash and cash equivalents will be used to pay employees' salaries in the coming months.
• The cash and cash equivalents are used to repay a loan that is due to mature shortly.
The core of the argument for "operational necessity" usually consists of the fact that certain operational measures are imminent, the liquid funds serve to finance these operational measures and/or no other form of financing would be available in the short and medium term or only on unfavorable terms.
The declaration of cash and cash equivalents as "not required for operations" means that they are declared available by definition and therefore represent an additional value that exists separately and independently of the intrinsic value of the company's operating business. The funds could also be distributed without damaging the value of the business.
Conversely, if cash and cash equivalents are declared as "essential to operations", this additional value contribution does not apply. In this case, the funds are a production factor within the original business operations. The total enterprise value can only be generated if these funds remain in the company. The value from the owners' perspective differs in both cases by the amount of cash and cash equivalents.
The core of the problem lies in the fact that the negative effect of the operational measure, be it an investment, future personnel expenses or loan refinancing, is already taken into account by the business valuation technique.
A company is founded on 31.12.2017 with capital of € 100,000. At the time of formation, contracts are concluded for investments totaling € 100,000, which provide for payment and provision of services on 1 January 2018. As at December 31, 2018, the plan is to sell the completed project for € 110,000 after taxes and then terminate the company. The cost of capital is 10% after tax. What is the value of the company after formation of the company and conclusion of the contract but before payment of the investment costs?
Value of the company as at 31.12.2017: € 100,000
The DCF method applies: cash inflow after taxes at the end of 2018 in the amount of € 110,000. At a cost of capital of 10% after taxes, this is worth € 100,000 as at 31.12.2017. Deduct € 100,000 from this for investments as at 01.01.2018. Add to this € 100,000 in funds not required for operations. This results in a total of € 100,000.
Are the liquid funds required for operations? No.
If, on the other hand, cash and cash equivalents are classified as "essential to operations" due to contractual obligations, then paradoxically this results in a value of zero, i.e. the company is "supposedly" worth nothing.
The DCF method would apply: Cash inflow after taxes of € 110,000 at the end of 2018. At a cost of capital of 10% after taxes, this is worth € 100,000 as at 31.12.2017. Deduct € 100,000 from this for investments as at 01.01.2018. The cash and cash equivalents are not included in the calculation, as they are supposedly "necessary for operations". This makes a total of zero.
The error in the aforementioned approach lies in the fact that the negative effect of the investment is counted twice. In addition, the example illustrates very well that a strict separation of financing and use of funds in the DCF method is particularly beneficial from a valuation perspective in terms of clarity and avoiding errors.
Examples of "essential" and "non-essential" cash and cash equivalents
The simplest example of non-operating cash is a bank balance without any restrictions on access or disposal by others. These funds are available to the owner at any time and can be distributed.
The classic case of cash and cash equivalents required for operations is cash management in the operating business. This is often the case in companies with chain stores (beverage markets, clothing chains, restaurant chains, etc.). A certain amount of cash must be held to ensure the smooth running of day-to-day business, as not all customers pay in cash and a lack of change could mean delays. These funds cannot be distributed to the shareholders, as this would restrict business operations. Instead, they have the character of working capital and are to be treated as such in terms of valuation.
Restricted cash is a special case. This refers to funds that cannot be distributed due to legal restrictions. This in no way refers to the above-mentioned case in which a "quasi" legal restriction on the distribution of liquid funds is derived from a contractual obligation to carry out an investment.
In this case, legal restriction means that there are certain requirements regarding the specific amount of cash and cash equivalents held by the company. Examples of this are
In these cases, it depends very much on the specific reason for the valuation and the specific facts of the case; it is not possible to make a blanket statement on treatment here. A significant reduction in value from the owner's perspective is certainly possible here, all the more so the more closely the restriction is linked to the original transaction.
In the vast majority of cases, liquidity is not essential to operations and should therefore be viewed as a positive, separable value contribution from the owner's perspective. Operational necessity, on the other hand, is given with a "minimum" of cash holdings, but rarely reaches a significant level. The special case of "restricted cash" can have a major influence; in this case, the valuer must assess the restriction on disposal on a case-by-case basis.
