Financial statements can make or break business value

Appraisal professionals typically consider three approaches when valuing a business — cost, market, and income approaches — ultimately relying on one or two depending on the nature of the business and other factors.

So, it’s no wonder that financial statements are an important piece of the business valuation process, and having accurate and updated financial statements can provide valuable insight into the fair market value of the business.

Cost approach leverages the balance sheet

Under U.S. Generally Accepted Accounting Principles (GAAP), a company’s balance sheet reports its assets and liabilities generally based on the lower of historical cost or market values. This is a logical starting point for the cost (or asset) approach to valuing a business.

Under this technique, value is derived from the combined fair market value of the business’s net assets minus any liabilities. This approach is particularly useful when valuing holding companies, asset-intensive companies, and distressed entities that aren’t worth more than their net tangible value.

The cost approach includes the book value and adjusted net asset value methods. The former calculates value using the data in the company’s accounting records. Its flaws include the failure to account for unrecorded intangibles and its reliance on historical costs, rather than current market values. The adjusted net asset value method converts book values to fair market values and accounts for all intangibles and liabilities (recorded and unrecorded).

Market approach relies on the balance sheet and income statement

The market approach bases the value of a business on sales of comparable businesses or business interests. Under this approach, the valuator identifies recent, arm’s-length transactions involving similar public or private businesses and then develops pricing multiples typically based on items reported on the balance sheet or income statement.

A pricing multiple is developed by dividing the sales prices of comparable companies by an economic variable (for example, book value or pre-tax earnings). Then, the pricing multiple is applied to the same economic variable as reported on the subject company’s financial statements.

The two main methods that fall under the market approach are:

• Guideline public company method.