Category: Accounting News

Whether it’s a company firing on all cylinders or a company on the verge of liquidation, determining correct valuations is not a cut-and-dry process. Understanding the importance of going-concern values and liquidation values is essential when determining a business’ worth.

Quantifying Going-Concern Value

When it comes to defining this type of value, it factors in the likelihood of a business operating indefinitely with continued profitability. With a company’s demonstrated ability to maintain profitability comes inherent value, reducing the likelihood of a business going bankrupt. 

In contrast to a business’ liquidation value basis, which might only be $20 million due to unsold goods, real property and associated physical assets, the going-concern value might be worth $120 million. The difference and increase in value are due to the additional equity embedded in its competitive position in its industry, its projected future cash flows, goodwill, etc. Goodwill consists of the company’s name, its intellectual property (IP) patent, trademarks, customer loyalty, etc.

When one company looks to acquire another, the company bases its valuation on the calculated going-concern value of the acquiree. When formulating its offer to purchase the other, it will factor in its future profitability, intangible assets, customer loyalty, and goodwill.

Liquidation Value Defined

Liquidation value is determined by establishing the net value of a company’s physical or tangible assets if they were to go out of business. It’s important to distinguish that intangible assets (intellectual property, brand significance, and goodwill) are not included in liquidation sales. Assets are often sold at a loss because the seller must turn the assets into cash quickly. Generally, liquidation valuation is higher than salvage value but less than book value. Though, to contrast with a traditional, non-acquisition sale, intangible assets are considered part of the sale/offer price.

One important concept for determining liquidation value is the recovery rate. Cash is naturally the highest level, usually at 100 percent. From there, assets such as accounts receivable (AR), inventory, property, plant, and equipment (PPE) have progressively lower recovery values. Determining these values will accordingly govern the success of a liquidation sale.

Comparing Values: Market vs. Book vs. Liquidation vs. Salvage

It’s important to highlight the hierarchy of values to illustrate why these types of valuations differ so much. Market value is the highest, though market conditions can temporarily lower them below normal valuations. Book value is the second highest, also known as historical, and it is what’s listed on the company’s balance sheet. Book values must be looked at through the lens of history and relative to inflation, etc. Salvage value is the second lowest valuation, which is also referred to as scrap value, or when an item is “at the end of its useful life.” Liquidation is the lowest value because tangible assets must be sold quickly, lessening the chance to find a buyer at a fair price.

How Liquidation Works

Liquidation is the difference between a company’s tangible asset value and liabilities. For example:

  1. Liabilities of a business are $750,000

  2. Balance sheet assets show a book value of $1.5 million

  3. Salvage value of assets is $250,000

  4. Auction sale estimate value is $1.2 million, or 80 percent

Liquidation Value = Auction Value – Liabilities ($1.2 million – $750,000 = $450,000)

Many variables must be studied to effectively determine a company’s value, regardless of what spectrum is being evaluated. Employees and consultants who have a better grasp of these methods will provide everyone involved with a fair assessment.

The accounting term working capital is essential knowledge for all business owners. Basically, it is the ability of a business to meet its ongoing obligations. Learning about some of the different aspects of working capital is vital for any successful business owner.

Net operating working capital (NOWC) is the gap between a business’ current assets (accounts receivable, inventories, cash, though excluding marketable securities) and its non-interest-bearing liabilities (which are financial obligations a business must meet, except those not subject to interest payments).

This calculation looks at a business’ cash flow availability and determines available current assets able to be liquidated inside a calendar year.

The formula is as follows:

NOWC = Current Assets – Non-Interest-Bearing Liabilities

Operating Working Capital (OWC)

OWC measures a business’ current assets and calculates how much the company’s day-to-day operations cost. This includes meeting supplier invoices, turning accounts receivable (AR) into cash, obtaining inventory, and making sales on inventory and/or services.

The higher the OWC, the easier it is for a business to pay supplier invoices, leverage pre-pay or early pay discounts, maintain healthy inventory stocks, and offer customers favorable terms to grow sales further.

OWC is calculated as follows:

OWC = Current Assets – Non-Operating Current Assets

It’s important to remember that cash isn’t included because this asset is considered a non-operating asset. While cash isn’t immediately connected to operations, it can be re-considered an operating asset once supplies and related items are obtained with it.

Operating Working Capital Considerations

The OWC calculation determines how proficient the business is with its finances. Since it immediately reveals the amount of funds a business has, the larger the resulting figure, the lower the funds a company has available to complete its rotation.

Companies can lower their results by increasing the rate of inventory turnover, increasing the percentage of customer payment collection, and working with vendors for better provider terms. As a business improves this metric, it can free up funds to reduce its loans, pay dividends, and/or build out new or existing revenue streams. 

Net Working Capital (NWC)

Also referred to as working capital, NWC is defined as the difference between total current assets held by a business and its liabilities. It shows a business’ level of liquidity. This looks at how capable a company is in generating profits, chiefly when it comes to near-term financial obligations (paying wages, electric bills, leases, etc.). It also tells a business if and how much it’s able to re-invest to grow profits and increase product or service capabilities.

It’s calculated as follows:

NWC = Total Current Assets – Total Current Liabilities

Total Current Assets = Cash Assets + AR + Inventory  

Current liabilities are short-term financial obligations due within 12 months, including accounts payable (AP) and accrued expenses.

Considerations

Positive net working capital implies a business can meet current financial obligations and invest in other operational needs. If the NWC is too high, the business isn’t using its short-term assets efficiently. Since some current assets can’t be converted to cash easily, NWC isn’t always the best measure of liquidity. It can similarly signify underused resources.

While there are unique considerations for every business, the more business owners and management are versed in these concepts, the more likely they are to increase their chances of surviving and thriving.

A trial balance is an accounting tool that helps businesses determine if the double entry accounting system has any mathematical errors. Once the trial balance is worked through, and the total debits and total credits equal each other, we know there are no mathematical errors – but that doesn’t mean it is error free. It is important to determine how it is constructed and the considerations for each step in the process.

Raw Trial Balance

The first is the unadjusted trial balance. This looks at all the double entry bookkeeping journal entries, which records the business’ day-to-day transactions. When beginning to prepare for the adjusted trial balance, the eventual adjusted trial balance will have three column headers: 1. Account 2. Debit 3. Credit.

It should list all sub-ledger account balance totals, the account description and number, along with the final debit/credit balance. It also should document the accounting period, including the starting and final dates.

The next step is to address balancing for each sub-ledger. Sub-ledgers, such as Cash, Accounts Payable and Accounts Receivable, are balanced from the sub-ledgers’ “T” account; the resulting credit or debit balance must be noted. Depending on the resulting credit or debit balance, it must be put in the right “Debit” or “Credit” column. If there is a mathematical error, it means the previous steps in the accounting cycle might have errors in them.

Adjusted Trial Balance

Along with the trial balance having the credits and debits entered from each respective sub-ledger, the first thing to check is if the credit and debit balances line up. Then, the next step is to determine if other mistakes may exist. Examples of non-mathematical mistakes include:

• Original entry errors or double entry transactions that contain mistakes on both ends.
• Omission errors or errors that result from not being put into the accounting ledger.
• An error of reversal is an error with double-entry transactions that has the correct numbers but transposes credits and debits.
• A principal error is a transaction that correctly records the transaction, the figures, the right side (debit v. credit), but attributes it to the incorrect account.

Along with these potential mistakes, a business can identify and take corrective action when reviewing its transactions on specific accounts and when aggregating sub-ledgers into their trial balance. Examples of corrective action include tax adjustments, such as ensuring any tax deductions that were missed are then added.

If business transactions were made on a personal credit card, they need to be adjusted accordingly. When it comes to accrual considerations, if a payment is owed but not made during an accounting period, it must be adjusted to reflect the correct accounting period. Another consideration is for payments received, which is often referred to as a deferral. Past due payments that are applied to a later accounting period but were for a previous accounting period must be adjusted accordingly.

Conclusion

The last step is to prepare the post-closing trial balance. Once the closing entries have been finished, it can help a company use it as a starting point when they need to do it again for the next accounting cycle.

While trial balances are only a part of the bookkeeping and accounting process, taking steps to reduce errors can make the accounting process a more insightful business function.