Cost approach to business valuation: description, essence and examples

In practice, the work of each company is subjected to analysis. In this case, a profitable, costly, comparative approach to business valuation can be applied. The need for analysis arises in a variety of situations. Let us further consider how the business is valued using the cost-based approach .

General information

In international practice, specialists use three approaches to assessment:

• costly;
• comparative;
• profitable.

The analysis of domestic organizations is regulated by the industry federal law, as well as federal standards (FSO). Each approach provides its own assessment methods.

Characteristics

The comparative approach includes three methods. In particular, an analysis is made of the capital market, industry ratios and transactions. The income approach is based on 2 options. They are an analysis of capitalization and discounted financial flows. The cost approach is also based on 2 methods: the method of net assets and residual value. They are used in almost all transformations of the organization. The analysis is performed upon acquisition or sale of production, corporation incorporation, acquisition, merger and so on.

Cost approach to assessing the value of the enterprise (business)

This analysis option has one key feature that distinguishes it from others. Business valuation using the cost-based approach is a piecemeal approach . As part of the analysis, the property complex is divided into certain components. Each item received is investigated, its price is revealed. In conclusion, all the indicators obtained are summarized, and the total value of the enterprise is displayed.

Key areas

The cost approach to assessing the value of a business combines:

1. The study of accumulation of assets of the organization.
2. Adjusted balance sheet value or the net asset method.
3. Determination of the liquidation price.
4. The method of substitution.

These options are combined according to one essential feature. They are based on determining the value of each particular type of property of the organization at current prices or the costs of creating a similar company (by the method of replacement) and subtracting the amount of all debts of the company. The analysis uses a single information base - balance.

Appointment

The cost approach to evaluating a business , as a rule, is used to obtain the information necessary for making various management decisions. This is the essence of this analysis. It can be explained how business valuation is performed using a cost-effective approach using the example of a company that is being sold, insured or liquidated. So, when selling a company, the market price is calculated by way of accumulating assets. With insurance, replacement cost is most often determined . At the closure of the enterprise, the liquidation price is calculated.

Benefits

The cost approach to business valuation has several advantages. The main ones can be considered:

1. The ability to account for the impact of economic or production factors on price fluctuations.
2. Use of a voluminous information base. The cost approach to business valuation is based on both accounting and financial documents. This, in turn, allows you to get more informed results.
3. The ability to analyze the degree of development of the technology of the company, taking into account the level of wear of real estate or equipment.

Disadvantages of the cost approach to business valuation

Meanwhile, along with the advantages, there are several negative points in the analysis. A specialist, taking them into account, may refuse to use a costly approach to evaluating a business . The most significant negative aspects of the method include:

1. Determining only the past price.
2. Inability to take into account the current market situation at the time of the analysis.
3. Static
4. Inability to take into account the risks and prospects of the company.
5. Lack of connection between the current and upcoming work results of a particular company.

The disadvantage of a costly approach to evaluating a business is also its complexity and complexity.

Net book price

The method for determining it is considered the simplest of all included in the costly approach to evaluating a business . To establish a net book price, all liabilities (short or long term) are deducted from the currency. The result will be the value in monetary terms of the equity of the company or its assets. The advantages of this method include:

1. The use of reliable information only on real assets that are owned by the company. This method eliminates the abstraction, which is inherent in other methods.
2. In market conditions, the method has the most comprehensive database.

Moreover, the method has several negative features:

1. It is impossible to take into account the effectiveness of the company and the prospects for its development.
2. The market situation is not taken into account in terms of the ratio of supply and demand for similar companies.

Consider how an assessment of business is carried out by a costly approach using an example. The initial balance sheet data is as follows (in cu):

• OS - 5000;
• reserves - 1000;
• accounts receivable - 1 thousand;
• cash - 500;
• debt obligations - 6 thousand

In accordance with the conclusion drawn up by the specialist, fixed assets of the company are 30% more expensive, and stocks of raw materials and materials are 10% cheaper. Accordingly, 20% of the receivables cannot be collected. Using the appropriate ratios, determine the carrying amount:

1000 x 0.8 + 1000 x 0.9 + 5000 x 1.3 + 500 - 6000 = 2700.

Disposal price

It is determined only if the company, having stopped performing operations, begins to sell its assets, to repay obligations. The calculation of liquidation value allows you to get the lowest rate at the price level. It reflects the minimum amount at which you can sell the company.

Adjusted book price method

It is considered one of the varieties of the costly approach. This method includes the final indicator of the balance sheet revision with adjustment of the residual price of assets taking into account the inflation factor. In the analysis, revaluation of funds is carried out. At the same time, the result obtained is entered into the balance sheet. This allows you to determine the adjusted, net price, which, in essence, acts as an indicator of the equity of the company and the reserve for its revaluation.

Substitution method

It focuses solely on the analysis of tangible assets and is valid only for capital-intensive companies. The assessment involves the calculation of the costs of the full replacement of the funds of the enterprise while maintaining the current economic profile. The analysis is performed in a specific sequence. First, accounting and statistical documents are evaluated. These include:

1. Quarterly reports.
2. Interim liquidation balance sheet.
3. Statistical reporting.
4. Inventory cards.

Based on the results of this comprehensive study, an idea is formed about the insufficiency or sufficiency of assets to pay off debt. After this, the property mass is created for valuation. The most / minimum circulating or liquid assets are separately studied. Then the total amount of the company's debt is formed and a repayment schedule is drawn up.

conclusions

The cost approach, based on an analysis of the company's balance sheet, allows you to get fairly objective indicators. According to some experts, it is the most reliable option in the current unstable economic conditions. The meaning of the assessment is the most accurate calculation of the market value of the enterprise. It analyzes all its assets, including tangible, intangible and financial.

The book value of these funds is influenced by market changes and inflation. Accordingly, it does not always coincide with the market price. This, in turn, necessitates an adjustment to the balance sheet. It is for this that each asset is evaluated individually.

After determining the current price of all obligations of the company, it is deducted from a reasonable market indicator for all property. The result obtained will be the price determined by the costly approach. The calculation of the liquidation indicator is used in the analysis of bankrupt companies or in the event of an alleged loss of solvency in the near future. This price shows the amount of remaining financial resources after the sale of the company, repayment of direct costs and other expenses.

Nuances

It should be noted that when assessing immovable objects of an enterprise, specialists must have at their disposal:

1. Construction and technical characteristics for each structure. It is formed in accordance with the data of the data sheet, which, in turn, is issued in the BTI. In addition, the characteristics of the capital construction department should be attached to the characteristic.
2. Reference information. Information should also be included on the funds needed for the repair, and on the costs associated with the restoration.

It is also worth noting that the value of the company, determined using the liquidation price method, never corresponds to real amounts. Here it is necessary to refer to paragraph 9 of the FSO. It says that the resale value of an object reflects the probable amount at which it can be sold during the exposure period.