Business Valuation

So, if a business valuation identifies factors that would put the earning of profits at risk, steps need be taken to minimise the effect of those factors in order to enhance the value of the business.

Business Value

The value of a business is often expressed as a multiple of the profits of the business. The lower the risk of earning those profits, the higher the multiple. For example, the value of a business in a particular industry may be four times its earnings before income tax (EBIT). And so the business would be earning 25 percent on its value. A more risky business may only be valued at three times EBIT, representing a 33.3 percent return on value.

The measure of profit used in the valuation calculation must exclude any ‘abnormal’ income and expenses, as well as interest. In some cases it can also exclude depreciation and amortisation of fixed assets. But it must include a deduction for the commercial remuneration paid to the owner.

Often the driver of the owner’s remuneration is to minimise tax, and bears no resemblance to a remuneration that would have to be paid to an employee undertaking the same tasks. In other cases, businesses are run at a level where the owner’s remuneration is acceptable to that owner but would be unacceptable to someone else. So in valuing a business consideration must be given to the time and effort put in by the owner (and owner’s family) and an adequate reward must be identified.

In the process of doing this, it’s common for the business owner to realise that their reward really isn’t sufficient and they then look at ways to increase it. These include employing others to do more of the administration tasks, delegating management to others, introducing more efficient accounting processes, and working more ‘on’ the business rather than ‘in’ the business.

The difference between the calculated value of the business and the total value of its tangible assets, such as stock, debtors, and plant and equipment (less creditors) is the business’ goodwill. If the calculated business value is less than the tangible assets, the goodwill is negative. So goodwill is not something that is calculated directly but is the result of the calculation above.

The value of goodwill is enhanced by improving the business value through factors such as those referred to earlier, including handing over management to others to reduce the owner’s personal association with the business.

If it appears that accounting records are unreliable, or if the business can’t produce current financial accounts, any prospective purchaser is likely to discount the value of the business because of uncertainty about its real profitability or even its legitimacy. It is therefore important that a business maintains reliable accounting records and can produce current financial accounts at any time.

As mentioned earlier, in looking at profitability, adjustments are commonly made for extraordinary items of income or expense and for expenses that are discretionary or personal to the business owners. For example, if there are motor vehicle expenses or overseas travel expenses for the benefit of the business owner, they would be added back in determining profit. Therefore, such expenses must be readily identifiable.

The availability of financial analysis of sales by customer, product, and geographic location, can also enhance value where the analysis points to a ‘low profit risk’ due to a good spread of customers or wide product base.

The sale of a business may generate a capital gain that is subject to capital gains tax (CGT). After valuing the business, owners should make sure they know what liability there may be for CGT and seek advice on how it may be minimised, as this will make the business more attractive in the marketplace.

It may be prudent to change the structure sooner rather than later to avoid an increasing impost of CGT as the value of a business increases with time and improved profitability.

* Dennis Mattiske is a partner with accountants and business and financial advisers HLB Mann Judd, Sydney.