Thursday, October 19, 2006

Balance Sheet Method

When a business buyer and seller come to the table, the often tough question of how much is a business worth must be answered. There are many valuation methods that are used, some very simple to understand and some very complex often involving higher level differential math. In most cases, parties are more happy with simpler methods that are easy to conceptually grasp. Here I will show you the most simple method of valuating a business, the Balance Sheet Method. In the balance sheet method, one only looks at the business's assets and liabilities to determine exactly how much it is worth. Let's take a look at a quick simple example. ABC Corporation has this balance sheet: Assets Liabilities Cash $100,000 Accounts Pay. $50,000 Factory $1 million Mortgage $500,000 In this example, there are $1.1 million in assets and $0.55 million in liabilities. The business is therefore worth $0.55 million, or $550,000. If you are familiar with GAAP, the body of general accounting standards, assets are carried at book value, which is often much less than market value especially for appreciating assets like real estate. Many will therefore use the Adjusted Balance method which takes into account the market value of assets. Let's say we reconsider the above example, and we see that ABC bought the factory 10 years ago. The industrial real estate in its market has appreciated so now the factory would sell for $1.5 million today. Now the worth of the business is $1.05 million instead of $0.55 million. Whether one uses the balance sheet method or more popular adjusted method, the approach is looking at what the business is worth based off its asset alone. It takes nothing into account of how much a business has in earning power. The balance sheet method lets one take the perspective of "I walked away from this business tomorrow, sold everything that it owns, how much do I get?"

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Blogger misk said...

A quick somewhat related question:
How do you make a 'standard' ratio analysis of a company with negative equity due to negative cumulative[though consequently decreasing] reteined earnings? Let's say
1.GE has 100% shares.
2.The business has incredible outlook/perspectives.
3.The company can deduct the loss from previous years for tax purposes but it doesn't affect the income statement values[that's how it is in Poland]
4.GE[or it's banks] is obviously the source of debt - or can't it be?
Now the questions:
1.Why can't GE just add money to the "initial" capital to offset the negative retained earnings - the company would still be able to tap into the tax benefits and have positive equity?
2. If retained earnings are negative as is equity, does it mean the costs are financed by loan?

Again, sorry for putting trah on your blog but I'm really desperate...

11:38 PM  
Anonymous Anonymous said...

Valuation of company based on actual value of assets is according to me the right way of valuation of company. In todays market the asset prices have fallen drastically and most companies stand to lose if the assets are valued based on current market price.

Valuation of assets which are physically present is possible, but how will you value asset like goodwill?

5:08 PM  

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