A business valuation is a method by which a company determines its current worth by converting its brand, products, services, and market into capital. When expanding their firm, combining with other companies, negotiating during an acquisition, or selling portions or all of their business, business owners generally do a valuation.
It will not only help you make transactions with confidence, but it will also give you peace of mind knowing your firm is on the right course. And there are numerous methods for determining your business valuation.
There are three basic techniques for assessing the value of a business, including the income-based, asset-based, and market-based approaches. This essay will focus on the asset-based strategy and will help you grasp everything about it. Continue reading to have a deeper understanding of asset-based business valuation.
The Asset Approach
The asset approach to business valuation uses the balance sheet of the company as of the valuation date to calculate value. It employs the fundamental balance-sheet equation: Assets = Liabilities – Equity.
This approach to calculating business value employs two key methods:
- The equity book value approach
- The method of the adjusted book value of equity.
The Book Value of Equity
The basic book value of equity technique establishes business value by utilizing the equity on the balance sheet of the organization. However, analysts do not commonly employ this strategy because it does not take into account two critical factors:
- The fair market worth of the company’s assets and liabilities is being assessed.
- The ability of the company to make a profit from its assets.
The absence of these critical criteria may result in a considerable undervaluation of the company.
Because the asset method is based on the balance sheet, it does not examine the assets’ ability to generate profit. As a result, it frequently undervalues a corporation since it disregards its ability to make a profit. To avoid this, analysts use the asset approach when a major amount of a company’s value is connected to its fixed assets rather than its potential to generate profit.
Adjusted Book Value of Equity
The adjusted book value of equity technique addresses the aforementioned issue by taking into account the unconsidered liabilities and fair market value of assets. It establishes the company’s floor value based on the amount earned by the business owner after selling assets and fulfilling liabilities. It does not require the firm to be liquidated but rather evaluates business value based on the fair market value of its assets or liabilities.
The adjusted book value of the equity approach makes the following adjustments:
Inventory.
This asset approach method adjusts inventory for businesses that report it on a last-in, first-out (LIFO) basis. LIFO eliminates recently purchased inventory items, resulting in inventory balance reporting costs incurred prior to the effective analysis date. It may not accurately reflect the current cost of replacing inventories.
The first-in, first-out (FIFO) accounting system more accurately portrays current market value. It is widely accepted to modify a company’s inventory to a first-in, first-out (FIFO) basis. Consider writing off slow-moving or obsolete merchandise as well.
Tangible assets.
In many cases, the book value of a company’s real property (such as land, land improvements, buildings, or personal property, such as machinery and equipment, furnishings and fixtures, automobiles, etc.) does not correspond to the fair market value of those items.
To assess the market value of your tangible assets, hire a professional appraiser.
Intangible assets and goodwill.
The equity method’s adjusted book value assigns no value to goodwill and intangible assets. Approaches based on income or market value better reflect the worth of these assets.
Accounts receivable and payable.
Consider if a receivable is entirely collectible or whether a payment will be fully paid. This is frequently the case for connected parties such as intercompany receivables or shareholder loans. Discuss pertinent accounts with management to see whether changes are required for potentially uncollectible receivables or payables that may never be paid.
Unrecorded assets and liabilities.
Adjust for unrecorded assets or liabilities, such as possible legal settlements or judgments.
The Asset Approach’s Advantages and Drawbacks
For organizations with significant value in fixed assets or with negative earnings, valuers employ the asset approach. This method assists in determining the lowest feasible value for the organization without taking into account its potential to create profits.
Advantages
The asset approach is used to appraise a company that is experiencing liquidity problems. It aids in determining the company’s basic level of value upon liquidation. However, adjustments are required to determine the assets and liabilities at their fair market values.
This technique is adaptable in terms of determining which assets and liabilities to value and how to value them. It contributes to the valuation of enterprises in the investing sector.
The asset approach is simple: assets minus liabilities. When adjusting assets and liabilities, the process becomes more complicated, although the arithmetic is straightforward.
You may like to read this article also: Business Appraisal Benefits: How to Make the Most Out of It?
Disadvantages
The asset approach ignores a company’s potential to earn profit from the products or services it provides. When the combined asset and income yield a lower value than the book value or adjusted book value or when the company’s worth is predominantly determined by its physical assets, analysts choose this method.
The method requires measuring items that do not appear on the balance sheet, which can be problematic. To assess business value using the asset technique, analysts must have a high level of attention to detail, experience, and accuracy. A lack of experience or adequate data may result in an incorrect appraisal.
Challenges in Asset Approach
Balance-sheet assets are valued at costless depreciation, not at fair market value; consequently, analysts must modify the value of those assets. A balance sheet, if it reflects them at all, does not show the correct value of intangible assets. Valuing intangibles such as trade secrets can be difficult. Making modifications to liabilities is also difficult because doing so may raise or lower their value, which affects the computation of business value.
Conclusion
An asset approach is a straightforward approach to valuation because it is based on the market value of a company’s equity, i.e., assets minus liabilities. The asset approach can be a more informed business valuation approach for businesses that own and manage assets, particularly for entities with substantial machinery and equipment balances.A qualified valuation specialist is required to comprehensively evaluate a company’s balance sheet and assess the modifications required to reflect the market value of the underlying assets and liabilities, as well as to establish whether the technique best represents the worth of the firm at hand.
