What is surplus cash, how to determine it and what impact does this have on business valuation?
Typically, we at PEM Corporate Finance value a sustainably profitable business by using the market method.
Calculating and arriving at an adjusted normalised level of profitability and multiplying the profit figure (usually adjusted EBITDA) by a selection of multiples from comparable listed companies and comparable transactions in addition to standard transaction indices and specific industry indices.
This calculation generates an enterprise value of the business which needs to be adjusted to reflect its balance sheet in order to arrive at the equity value of the business, the value attributable to the shareholders.
In simple terms, one would add the cash balance and subtract the total debt figure from the enterprise value. From this you then get to a net cash or net debt position. To determine how accurate this is we consider the following important factors in determining surplus cash.
Firstly, one needs to analyse the total cash balance on the balance sheet and what it’s comprised of. How much of this cash is ‘free cash’ and how much is ‘trapped cash’? There may be cash that is held as security, deposit or on behalf of a customer. All the trapped cash should be deducted from the surplus cash calculation.
This is a crucial factor in determining the surplus cash figure. Looking at the latest balance sheet of a business may give you a cash balance, but is this cash balance artificially inflated due to the business owners aggressively collecting its debtors unusually quickly and delaying payment to creditors?
When valuing a business, we have traditionally tended to look at the last 12 months monthly balance sheets as this helps calculate a normalised level of working capital. This would then be compared to the working capital figure as at the date of valuation and any shortfalls should result in an adjustment to decreased surplus cash figure and vice versa.
However, this ultimately comes back to understanding in detail the business that you are valuing. There may be several genuine factors and clear business rationales contributing to a change in the working capital dynamic of the business i.e. perhaps they have changed to a supplier with more advantageous payment terms etc.
The current pandemic has put a spotlight on business resilience and how important cash management is to a business. This has moved the goal posts, as it were, for many businesses on the minimum level of cash needed to be maintain ongoing operations.
Extra care should now be taken when valuing businesses in the current climate. Retrospective analysis of working capital may not be prudent or representative of the business going forward.
In the end, there is no precise method or rule on how surplus cash should be calculated. However, there is general rule of thumb which is could the cash theoretically be paid out to the shareholders via dividend without prejudicing the ongoing operations of the business?
The overarching message is that you really need to understand the business, and all its intricacies, when determining its value.