The following article provides brief and concise information on the relationship between investments and depreciation in perpetual retirement.
Alleged cases of “operational necessity” of cash and cash equivalents in company valuation
The question of whether a company's cash and cash equivalents are operationally necessary or not usually has to be answered differently in the context of a company valuation than in the context of an annual financial statement audit, restructuring, impending insolvency or in comparable circumstances. Auditors in particular regularly act as company valuers, but are also in demand as contacts when evaluating the economic situation of a company. This often results in the term being misinterpreted in the evaluation context. The following article attempts to sharpen the term “operational necessity” of a company's cash and cash equivalents in the context of company valuation.
Evaluators regularly justify the operational necessity of cash and cash equivalents on the basis of the fact that the cash balance at the valuation date is intended to finance certain operational measures and is therefore essential for operation. Here are a few examples of cases of “alleged” operational necessity of liquid assets:
- Cash and cash equivalents at the valuation date are used to finance an already planned investment project
- The cash and cash equivalents will be used to pay employees over the next few months
- The liquid assets are used to repay a loan that is due to mature shortly
The core of the argument for “operational necessity” is usually that certain operational measures were imminent, the liquid funds were used to finance this operational measure and/or that no other form of financing or would only be available on unfavourable terms in the short and medium term.
Effect on the market value of equity
The declaration of cash and cash equivalents as “not operationally necessary” means that they are declared available by definition and thus 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 transaction.
Conversely, if liquid assets are declared “operationally necessary”, this additional added value does not apply. In this case, the funds are a production factor within the original business operation. The total company value can only be generated by keeping these funds in the company. In both cases, the value from the owners' point of view differs by the amount of liquid assets.
Why is the nature of liquid assets often misjudged?
The core of the problem lies in the fact that the negative impact of the operational measure, whether it is an investment, future personnel costs or loan refinancing, has already been taken into account by the technology of company valuation.
example: A company is founded on 31.12.2017 with a capital of €100,000. At the time of establishment, contracts for investments amounting to a total of 100,000€ are concluded, which provide for payment and provision of services on 01.01.2018. On 31.12.2018, it is planned to sell the completed project for 110,000€ after tax and then to close the company. The cost of capital is 10% after tax. What is the value of the company after the company was founded and the contract was concluded but before payment of the investment costs?
Value of the company as at 31.12.2017: €100,000
In the DCF procedure, the following applies: Cash inflow after tax at the end of 2018 in the amount of €110.00. With capital costs of 10% after tax as at 31.12.2017, these are worth €100,000. 100,000€ must be deducted from this for investments as of 01.01.2018. In addition, 100,000€ of non-operational resources are added. In total, this results in 100,000€.
Are cash and cash equivalents necessary for operation? No
On the other hand, if you classify the liquid assets as “operationally necessary” on the basis of contractual obligations, the result is paradoxically a value of zero, i.e. the company is “supposedly” worth nothing.
In the DCF procedure, the following would apply: Cash inflow after tax at the end of 2018 in the amount of €110.00. With capital costs of 10% after tax as at 31.12.2017, these are worth €100,000. 100,000€ must be deducted from this for investments as of 01.01.2018. The cash and cash equivalents are not included in the calculation, as they are supposedly “operationally necessary”. This makes a total of zero.
The error in the above-mentioned approach is due to the fact that the burdensome effect of the investment is counted twice. The example also illustrates very well that, especially in the DCF process, a strict separation of financing and use of funds from an evaluation perspective is good for clarity and prevention of errors.
Examples of “operationally necessary” and “non-operationally necessary” cash equivalents
The simplest example of non-operational liquid assets is a bank balance without any access restrictions or orders from others. These funds are always available to the owner and can be distributed.
The classic case of operationally necessary cash equivalents is cash management in operating business. This is often the case in companies with branch stores (beverage stores, clothing chains, restaurant chains, etc.). For day-to-day business to run smoothly, a certain amount of cash management is necessary, as not all customers pay in cash and a lack of change could mean delays. These funds cannot be distributed to shareholders as this would restrict business operations. Rather, they have the character of working capital and should also be treated in exactly the same way in terms of valuation technology.
Special case: “restricted cash”
So-called “restricted cash” is a special case. This means funds that are not eligible for distribution due to legal restrictions. This does not mean the above-mentioned case in which a “quasi-” legal restriction on the distribution of liquid assets is derived from a contractual commitment 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 in the company. Examples include:
- Tenders in long-term transport contracts sometimes provide for payout restrictions in order to ensure that the transport company fulfils the contract.
- Depending on the country, civil law regulations may (temporarily) prohibit the cross-border payment of dividends.
- Cash must be deposited in accounts outside the disposal of the company as security, possibly even with an assignment of interest.
In these cases, the specific reason for the assessment and the specific facts are very important; a general statement about the treatment is not possible here. From an owner's point of view, a significant reduction in the value is entirely possible here, all the more so as the restriction is linked to the original business.
Conclusion: Cash and cash equivalents are usually not operationally necessary
In the vast majority of cases, liquidity is not operationally necessary and should therefore be regarded as a positive, separable value contribution from the owner's point of view. Operational necessity, on the other hand, exists with a “minimum” of cash holding, but rarely reaches a significant order of magnitude. The special case of “restricted cash” can have a major influence; in this case, the appraiser must assess the restriction on a case-by-case basis.