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06 Aug

Do financial statements reflect the value of a business?

Posted in General valuation topics on 06.08.09

A recent article in the Journal of Accountancy, “Four Options for Measuring Value Creation”, brought up some very good points regarding why the financial statements of a company are flawed as measures of value. The article lists a number of reasons, but top on the list is that value is future oriented, whereas most of the measures on financial statements are historically based. Value is based on anticipated future benefits.

So what does a balance sheet tell you about a business? A balance sheet typically has the historical net cost of the assets a business has acquired over time. The balance sheet does not tell you the type of assets, their age or condition. Older assets may be depreciated and have a very low book value, but still be fully functional in the business. The balance sheet does not indicate what future capital expenses will be to either replace old equipment or to support future growth. Intangible assets, including intellectual property and goodwill, are usually not reflected on the balance sheet even though they may have substantial value.

A balance sheet reports the liabilities of a company. Unless you are reading footnotes to the financial statement (assuming the financial statements have footnotes), the balance sheet usually does not tell you the terms of the liabilities or when they mature. It also does not reflect how old the payables are or whether the company has unused lines of credit. Understanding the obligations of a company is necessary in understanding its value.

Is value better reflected on the income statement of a company? Many people think that profitability, which is reflected on the income statement, the primary element contributing to value. There are two potential problems with this assumption. First profitability is not the same as cash flow. For example, necessary investments in capital expenses for new equipment can impact cash flow while having a minimal impact on profitability. The other issue is the assumption that the level of profitability reported will be sustainable. A business can have increasing sales over a prior year, but if its receivables are increasing at a faster pace, there could either be a problem with collections or the growth may not be sustainable.

Financial statements provide important, but limited information about a company.  Understanding the financial statements is only the beginning in the process of determining the value of a company.

©2009 Florida Business Valuation Group


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