How to Determine the Value of Business Ownership Interest

As the size and complexity of a firm grows, the ability to identify what money (i.e. cash) came and went during a period becomes more daunting.

By Jeff Compton
November 30, 2015
Originally published in Texas Lawyer.

“What money came into and went out of the business?” One might ask this question to understand not just what happened to cash, but whether a business is valuable by virtue of its ability to generate positive cash flows or whether the enterprise can meet its obligations.

Generally accepted accounting principles tell us “the primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period.” Useful information in many contexts.

As the size and complexity of a firm grows, the ability to identify what money (i.e. cash) came and went during a period becomes more daunting. Simply going through the bank deposits and withdrawals becomes less feasible as size and complexity of operations increase.

Fortunately, as size and complexity increase, so does the likelihood the firm will prepare a statement of cash flows internally and in turn its auditor will opine upon this particular financial statement within the audit.

The statement of cash flows performs the tasks of organizing the cash receipts and disbursement and demonstrating those cash flows presented represent the change to the bank accounts (i.e. the change in cash) during the period covered by the statement.

To accomplish this helpful organization, the statement uses three categories of cash flows: operating, financing and investing.

Operating cash flows begin with net income coming directly from the GAAP income statement. Because GAAP accounting uses the accrual method, recognizing income when earned and expenses when incurred, adjustments are needed to arrive at the cash basis income. In other words, the operating cash flows represent the net cash provided during the period from operating activities—a useful figure for many purposes.

The specific adjustments shown on the statement of cash flows to arrive at operating cash flow add back expenses that were incurred but not paid, with corresponding deductions for income earned but not received. Examples are: depreciation being added back to net income because it is not a cash outlay; accounts receivable increases over the prior period being subtracted because they are not cash collections and accounts payable increases being added back because they are not cash outlays. Other examples can be seen in the illustration.

Investing cash flows inform the reader as to the cash effect of transactions not captured on the income statement. Examples of these transactions are: additions for collected funds from the sale of an asset along with collections of notes receivable and subtractions for purchasing assets (capital expenditures) along with the purchase of another company. These also appear in the illustration.

Financing cash flows, as one expects, tell the reader what the firm has transacted in cash with its debt and equity financing sources. Positive amounts come from borrowings of debt or issuances of equity while negative amounts relate to corresponding repayments, including dividends.

The sum of the cash flows from the three categories, operating, financing and investing, equals the change in the cash of the firm’s bank accounts during the period covered, typically the calendar or fiscal year. This is proved by a reconciliation at the bottom of the statement of cash flows reflecting the beginning cash balances with the sum of operating, financing and investing cash flows added with that sum shown to equal the ending cash balances. The reader of the cash flow statement benefits from its overview of what “money” or cash came into and out of the firm during the period.