Valuing a Company Using Audited Financial Statements – What You Need to Know

When establishing the fair market value of the shares or assets of a business, a professional valuator will often use the entity’s historical financial statements as a starting point. A common valuation technique involves the application of a multiple (known as a capitalization rate) to historical results such as cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA).

In Canada, fair market value is defined in Practice Bulletin No. 2 of the Canadian Institute of Chartered Business Valuators as:

“the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

Since valuations are intended to reflect the price at which a business would change hands in a notional or hypothetical open market, it is important that the cash flow or EBITDA considered in the valuation analysis be normalized to reflect market-based assumptions.

Therefore, even if financial statements are prepared in accordance with Accounting Standards for Private Enterprises (ASPE) or International Financial Reporting Standards (IFRS) and audited or reviewed by an independent accountant, some adjustments are often required to determine “normalized” cash flow or EBITDA for the purpose of determining fair market value.

Some common examples of normalization adjustments that are considered in earnings or cash-flow based valuation approaches are discussed below.

Non-Recurring Items

Historical income or expense items that are non-recurring are generally deducted or added back in determining normalized earnings or cash flow, since the goal is to estimate what the earnings or cash flow will be on a going-forward basis. Examples of non-recurring items that are often normalized when establishing the fair market value of the shares or assets of a business include:

• Professional fees related to a reorganization or litigation
• Unusual or significant bad debt expenses (such as following the bankruptcy of a large customer)
• A gain or loss on disposal of property and equipment
• Revenues and expenses relating to discontinued operations

Related Party Transactions

Many businesses engage in transactions with related parties such as sales or purchases in the ordinary course of business or the payment or receipt of management fees or rent, among others. However, such amounts may not be reflective of market value, since the parties are not dealing at arm’s length. Following the hypothetical sale of a business to a third party, related party transactions will often not continue at the same terms.

Therefore, when establishing the fair market value of the shares or assets of a business in which related party transactions are significant, normalization adjustments may be required to reflect the financial results of the business had the transactions been negotiated on an arm’s length basis.

Income or Expenses Relating to Redundant Assets

Redundant assets are assets that are not related to a business’s core operations and that could be extracted from the business without affecting its operating ability. Some examples of redundant assets are marketable securities held for investment purposes or a rental property unrelated to the entity’s core business. In performing a valuation, redundant assets are considered separately (in addition to) the fair market value of the core operations. Therefore, the income or expenses relating to the redundant assets should be eliminated in arriving at the normalized cash flow or earnings from operations.

Salaries Paid to Management

In owner-managed businesses, owners may pay themselves through a salary, dividends or some combination of the two. Compensation may also be based on the owner-managers’ lifestyle and disposable income needs (rather than their role in the company). Therefore, it is often the case that an owner-manager’s salary is not reflective of market-based compensation for his or her position. In determining fair market value, it is important that salaries are normalized to reflect what it would cost to hire an unrelated person to perform the owner-manager’s role.

The above examples are just some of the normalization adjustments often required in determining the fair market value of the shares or assets of a business, even when relying on audited financial statements. A professional business valuator can help to identify these and other adjustments specific to each business.

Alissa Kahan, CPA, CA, CBV, CFF is a Senior Manager with MNP’s Valuations team in Montreal. To learn more on valuing a business, contact Alissa at 514.861.9724 or at [email protected]

READ MORE: Discover the Hidden Benefits of Valuing Your Business