When a couple is divorcing in an equitable distribution or community property jurisdiction and their assets include ownership in a closely held company, the value of the business typically must be determined.
Analyzing the company’s cashflow is imperative during such a valuation. This is true whether the couple tries to establish the value themselves—with or without the assistance of their divorce attorney—or if they hire a professional who is experienced in performing business valuations for divorce purposes.
We have seen many cases where litigants or their attorneys attempt to place a “value” on a business by:
- using the equity value on a company’s historical cost-based balance sheet (which is equity at book value and not necessarily a reliable indication of fair market value).
- capitalizing the operating income or net income of the company on the income statement (also called profit and loss statement).
These “quick and dirty” methods may, by mere coincidence, provide a reasonable estimation of the fair market value of the company. However, the uses and management of cash flow are crucial to a business, so the cash flow statement of the company should be examined in conjunction with the balance sheet and income statement.
CASH FLOW STATEMENTS
For companies using accrual accounting to report net income, revenues are recorded when earned—not necessarily when cash is received. Expenses are recorded when incurred-not necessarily when cash is paid, so profit may bear no relationship to increases in cash. A business must have cash to pay bills and make distributions to owners.
A statement of cash flows, which reconciles net income and cash, may be the most underutilized, yet most helpful, schedule in the financial statements of a company.
ANALYZING CASH FLOW AND NET INCOME
Is cash flow or accrual net income more relevant to a business valuation? Consider the following:
|Cash Flow (CF)||Accrual Net Income (NI)|
|CF to equity owners is calculated as net income adjusted by non-cash items and changes in working capital accounts on the balance sheet, less capital expenditures, investments, and acquisitions, plus proceeds from new debt less payments on debt. A business can have good cash flow but not show a profit.||NI is calculated as sales minus cost of goods sold, selling, general, and operating costs, depreciation, interest, taxes, and other expenses. A business can report a profit but not have adequate cash flow.|
|CF is the lifeblood of a business. It is needed to pay operational costs, suppliers, and bankers. If operating CF differs from NI, this indicates that further analysis is necessary.||The amount by which revenue exceeds expenses is an indicator of company’s profitability, but not necessarily its cash flow.|
|CF can be more difficult to manipulate than NI. Calculation of operating cash flow can indicate if working capital was manipulated to boost or decrease NI.||NI can be subject to manipulation through steps that impact cash flow, such as tightening/loosening credit policy to slow/boost sales, accelerating/slowing paying suppliers to decrease/increase cash, and others. There will be indications of these types of business decisions in the cash flow statements.|
HOW EXPERTS CAN HELP
An astute business valuation expert will attempt to isolate any manipulations of net income by interviewing company management and the company’s outside CPA about accounting policies used, operational decisions made, and any changes during the analysis period.
While net income can be subject to manipulation, this is not necessarily an indication of fraud. If fraud is suspected and a financial investigation is determined to be necessary, we suggest our clients hire a certified fraud examiner or forensic accountant.
The analysis of both cash flow and net income are crucial to the valuation of a company. In our work preparing business valuations for divorce purposes , the discrepancy between the net income and cash flow of a company is a frequent reason for divergent expectations of company value between the owner and non-owner divorcing spouses.
A credible business appraiser will analyze the company’s:
- Assets and liabilities on the balance sheets.
- Profitability on the income statements.
- Cash Flows on the cash flow statements.
Analysis of a company’s balance sheets and income statements in conjunction with the cash flow statements will give the most complete indication of a company’s financial performance and health, and provide the most complete suite of financial data to be used in the determination of company value.
To learn more about our business valuation services, contact us for a consultation.