How cash, debt and debt-like items change what the shares are worth

The short answer, explained

An earnings-based valuation usually values the operating business on the assumption that it has no surplus cash, no borrowings and a normal level of working capital. That figure is the enterprise value. A buyer of the shares, however, takes the company as it actually is, with whatever cash sits in the bank and whatever it owes.

To get from the business to the shares, the valuer adds cash the business does not need to trade and deducts interest-bearing debt and other amounts that behave like debt. The result is the equity value. Our guide to enterprise value vs equity value explains the two concepts. This page deals with the individual items in the bridge and how each one is tested.

Operating cash and surplus cash

Not every dollar in the bank is spare. A business needs cash on hand to pay wages, suppliers, rent and its next activity statement. That operating cash is part of what produces the earnings, so it is treated as already inside the enterprise value.

Surplus cash is the balance above that requirement. A valuer looks at the timing of payroll and supplier runs, seasonal swings, the bank balance across the year rather than on one day, and any amounts held for a known payment (for example, a tax bill due next month). Cash set aside for a specific liability is not surplus if that liability is not also deducted.

Interest-bearing debt

Bank loans, overdrafts, equipment and vehicle finance, and other borrowings that carry interest are claims on the business ranking ahead of the shareholders. They are deducted at the balance owing at the valuation date, plus any accrued interest and any break costs that would arise on the basis of value adopted (for example, where the debt must be repaid on a sale).

Debt-like items

Some liabilities are not called debt in the accounts but work the same way: they will consume cash, and the earnings used to value the business do not already pay for them. Common examples are:

• Unpaid tax amounts, such as outstanding activity statements and instalments for periods before the valuation date. business.gov.au notes these may need to be lodged and paid on a change of ownership. Income tax owed for earlier periods is treated the same way.
• Employee entitlements such as accrued annual leave and long service leave. The Fair Work Ombudsman explains that on a transfer of business, accrued annual leave either carries across to the new employer or, where the employers are not associated entities and the new employer does not recognise prior service, is paid out by the old employer. In a share sale the employer does not change, so the obligation stays inside the company being valued.
• Deferred revenue and customer deposits where the customer has paid and the work has not been done. The cash may be sitting in the bank balance, but the cost of delivering the work is still to come. Valuers differ on whether to deduct the full deposit or only the cost to complete the work, and on whether to allow for the tax deduction when leave or delivery costs are paid. The report should state the approach.
• Shareholder and related-party loans owed by the company. See shareholder loans for how these are separated from the share value. A loan running the other way, from the company to a shareholder, is an asset of the company only to the extent it is recoverable, and it may raise Division 7A questions that the ATO describes and that are for the company's tax adviser.
• Leases, as a policy choice. Where AASB 16 applies, a lessee recognises a right-of-use asset and a lease liability. If the valuation earnings are measured after rent is paid, the lease cost is already reflected and the lease liability is not deducted again. If the earnings are measured before rent, the lease liability is deducted. Either can be consistent; mixing them is not.

The double-counting test

Working capital and debt-like items overlap. Unpaid GST, PAYG withholding, accrued wages and customer deposits can sit in either place. The rule is simple: each item goes in one bucket only.

If the valuation assumes a normal level of working capital that already includes a liability, deducting the same liability in the bridge counts it twice and understates the shares. The schedule supporting the valuation should list every balance sheet item and show whether it sits in working capital, in the bridge, or outside the valuation altogether.

Worked example: a hypothetical bridge

This example is hypothetical. All figures are round numbers chosen to show the steps, not evidence of any market value.

A company's operating business is valued at $2,000,000 on a cash-free, debt-free basis with a normal level of working capital. Its bank balance is $350,000, of which $150,000 is needed to trade, leaving $200,000 surplus. Normal working capital excludes the employee entitlements and the customer deposits shown below. Earnings are measured after rent, so the premises lease is not deducted. Actual working capital at the valuation date is assumed to equal the normal level; if it were lower, the shortfall would be deducted, and any excess added.

Check: the deductions total $400,000 + $60,000 + $45,000 + $70,000 + $30,000 + $90,000 = $695,000. $2,200,000 less $695,000 is $1,505,000.

Now assume instead that the normal working capital figure already included the $70,000 of leave. Step 6 would then be removed, and equity value would be $1,505,000 plus $70,000, or $1,575,000. The same company, with the same balance sheet, produces a different answer purely because of where one item was placed, which is why the enterprise value must be struck on the same working capital definition used in the bridge, and the two have to be read together.

You can test your own figures with the enterprise to equity value calculator.

Limitations

• The bridge gives the value of all the shares. A particular holding may be worth more or less than its percentage; see is a minority shareholding worth its percentage.
• A sale contract can define cash, debt and working capital differently from a valuation. Where there is a contract, its definitions govern the price adjustment.
• Contingent liabilities, disputes, guarantees and tax exposures need separate assessment and are not captured by a simple bridge.
• This page does not give tax advice. Questions about Division 7A, tax on a sale or the treatment of loans belong with the company's tax adviser.
• Assets outside the operating business, such as an investment property or shares in another company, are valued separately and added; they are not surplus cash.

Next steps

• Gather the balance sheet at the valuation date, the loan statements and the payroll leave report.
• Ask your accountant to mark each balance sheet item as working capital, debt or debt-like, or outside the valuation.
• Work out how much cash the business needs across a normal month, using a year of bank statements rather than one balance.
• Run the figures through the enterprise to equity value calculator before asking for a formal valuation.

General educational information, not financial, tax or legal advice. Worked examples are hypothetical and do not value a real business. A valuation depends on its purpose, the evidence and the agreed scope.