Valuation: Introduction to "net debt" (cash & debt free)

Valuation: Introduction to “Net Debt” (cash & debt free)

Joris Kersten, Place Egypt, 19th February 2020

Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).

This at leading (“bulge bracket”) investment banks, corporates and universities.

I also provide inhouse training on request and I have open training programs in business valuation in The Netherlands and different places in the world (e.g. New York, Mumbai, Dubai, Amsterdam and Uden).

My full training calendar can be found at the very end of this article. And my next upcoming training is: Business Valuation & Deal Structuring @ Uden/ The Netherlands @ 18, 19, 20, 21 and 23, 24 March 2020. Visit for all info and registration: www.joriskersten.nl

In addition, I write blogs and articles on business valuation related issues, earlier blogs can be found at the very end of this article.

Introduction to “net debt”

In M&A transactions (Mergers & Acquisitions) most businesses are sold “cash & debt free”.

In the upcoming blogs I will explain what “cash & debt free” means, and an important concept with this is “net debt” and “adjusted net debt with cash like and debt like items”.

But before I will dive into these concepts, let’s first get the basics clear. This since we need to understand them first in order to address “net debt” and "adjusted net debt".

I will now start with giving a brief introduction on the P&L for valuation. Then I will continue with the balance sheet and the cash flow statement.

After this blog with brief introductions to the 3 financial statements I will talk in the next blogs about the much debated concepts in valuations and M&A:

1.     Net debt: Cash & debt free;

2.     Adjusted net debt with cash like and debt like items.

Profit & Loss Statement (P&L): Turnover

In valuation in general we start with analyzing the P&L of a company.

And this P&L starts with turnover.

When we look at turnover, we look at the five main elements:

1.     Organic growth, also called “like for like growth” (LFL);

2.     Growth through acquisitions;

3.     Changes in group consolidation;

4.     Exchange rate effects, and,

5.     Bookkeeping changes.

Only organic growth and growth through acquisitions can increase value since the other elements are just driven by bookkeeping or incidental events.

For valuation it is especially important to analyse the “organic growth”.

And we analyse "organic growth" in depth on the following 8 aspects:

1.     The business model.

You need to find out whether the company makes money with sales of products, subscriptions or contracts, or renting or interest income.

2.     Price/ volume effects

It is critical to understand the classical P * Q (price times quantity) for every product/ service group.

3.     Product market combinations (PMCs)

Another classic is finding out what the PMCs are. So you really need to figure out which current and new products/ services are sold on which current and new markets.

4.     Market growth and drivers for market growth

You also want to find out how much the company grew in relation to the market. And we want to know what the drivers for growth in the market(s) of the company are, including the past and recent trends.

5.     Estimated turnover growth in future years

You want to find out whether the growth comes from the market or stealing market share. And do not forget to take into account that “low hanging fruit opportunities” are most likely taken already ...

6.     Quality of turnover

Find out issues like: % repetitive turnover, revenue recognition policies, customer concentration, product/ service cycle, sector & country risks, turnover to related parties etc.

7.     Order book

To check the order book is a no brainer. And you can compare this to the books of competitors and to the ones of the company itself in prior years.

8.     Produced turnover

Production and building companies also create operating value with unsold production. You will see this back on their balance sheets as finished products and work in progress.

So for these companies we can adjust the P&L for produced turnover: Net sales + 'delta' finished good + 'delta' work in progress. Over longer periods produced turnover should not be lots higher or lower than turnover sold.

(Taco Rietveld, 2017)

P&L: EBITDA

Earnings before interest, tax, depreciation & amortization (EBITDA) is the operating profit before interest, tax, depreciation and amortization as the abbreviation tells us.

The EBITDA is very popular because it is the operating profit before the chosen way of depreciation, the tax regime and the capital structure (interest).

The downside is that the EBITDA is driven out of CAPEX (capital expenditures) from the past, and depreciation on these is not taken into account.

Moreover, we need to “clean” these EBITDAs for so called "nonrecurring items" in order to give a fair representation.

(Taco Rietveld, 2017)

P&L: Cleaning EBITDA

With extraordinary gains and losses in the EBITDA we mean gains and losses that most likely only take place once.

And we also call these gains and losses: “one-offs”.

Here we also mean non-operating gains and losses.

Quite common “one-offs” are:

1.     Re-organisation costs;

2.     Transaction costs of acquisitions;

3.     Costs for consultants;

4.     Profits on selling assets;

5.     Impairments on assets;

6.     Goodwill impairments;

7.     Exchange rate profits or losses;

8.     Profits out of discontinued operations;

9.     One off changes in operating provisions.

And quite common non-operating gains or losses are for example:

1.     Subsidies;

2.     Changes in operating provisions;

3.     Pension costs (with exemption of service costs);

4.     Costs of employee options.

All these extraordinary profits or losses need to be cleaned out the EBITDA.

(Taco Rietveld, 2017)

Balance sheet: Introduction

On the balance sheet we find assets that we can classify as:

·       Operating assets;

·       Non-operating assets (excess cash + cash like items).

And on the equity & liability side we can find:

·       Equity;

·       Operating liabilities:

·       Non-operating liabilities (debt like items);

·       Financial liabilities.

When I discuss “net debt” further in the subsequent blogs over the upcoming weeks, I will get back in much more detail on the balance sheet.

(Taco Rietveld, 2017)

Cash flow statement: An introduction

Cash flows are in general classified in four elements in a valuation setting:

1.     Cash flow from operations (EBITDA and taking 'deltas' in working capital into account);

2.     Investment cash flows (CAPEX);

3.     Cash flow from non-operating activities (example is interest income from cash);

4.     Financing cash flow from financing activities.

It is very important to understand the cash flow statement with “cash in” and “cash out” in relation to the P&L with “revenues” and “costs”.

Since "revenues" are not always a "cash in", and "costs" not always a "cash out", we get (temporary) assets and liabilities on the balance sheet.

And we need to assess these assets and liabilities when evaluating “net debt” in the next blogs.

(Taco Rietveld, 2017)

Next blog upcoming week: Net debt/ cash & debt free

After this blog with brief introductions to these 3 financial statements I will talk in the next blogs about the much debated concepts in valuation and M&A:

1.     Net debt: Cash & debt free;

2.     Adjusted net debt with cash like and debt like items.

Stay tuned! :-)

And do not forget to check my older blogs on valuation and discounts rates given below.

Source used for this blog

·       Book: “Investeren & Financieren: 2nd edition” of Taco Rietveld (2017). Publisher: Vakmedianet.

I am quite sure that right now this is one of the most complete handbooks on valuation and M&A. The level of detail in the book is amazing and the book is extremely practical.

Unfortunately the book is only available in Dutch, but definitely worth it to read for any Dutch finance & accounting professional involved in valuation and M&A.

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Article 9: Valuation: Different DCF & WACC techniques

https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/

Article 10: Valuation of a company abroad

https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/

Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts

https://www.dhirubhai.net/pulse/valuation-illiquidity-discounts-control-premiums-joris/

Article 12: Valuation: Small firm premiums

https://www.dhirubhai.net/pulse/valuation-small-firm-premiums-joris-kersten-msc-bsc-rab/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Earlier blogs on Wall Street

Article 1: Wall Street – A general introduction

https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/

Article 2: Wall Street – The Federal Reserve banking system

https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/

Earlier blogs on Financial Modelling

Scoping a financial model built primarily for business valuation:

https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/

Training agenda Joris Kersten:

• Financial Modelling in Excel (5 days): 2, 3, 4, 5, 6 February 2020. Location: Riyadh/ Saudi Arabia;
• Business Valuation & Deal Structuring (6 days): 18, 19, 20, 21 and 23, 24 March 2020. Location: Uden/ The Netherlands;
• Financial Modelling in Excel (4 days): 20, 21, 22, 23 April 2020. Location: Uden/ The Netherlands;
• Business Valuation & Deal Structuring (5 days): 22, 23, 24, 25, 26 June 2020. Location: New York City/ United States.
• Business Valuation & Deal Structuring (5 days): 19, 20, 21, 22, 23 July 2020. Location: Dubai/ United Arab Emirates.
• Business Valuation & Deal Structuring (5 days): 3, 4, 5, 6, 7 August 2020. Location: Mumbai/ India.
• Business Valuation & Deal Structuring (6 days): 28, 29, 30, 31 October 2020 + 2, 3 November 2020. Location: Amsterdam/ The Netherlands.
• Financial Modelling in Excel (4 days): 16, 17, 18, 19 November 2020. Location: Amsterdam/ The Netherlands.

All info on these open training sessions can be found on: www.joriskersten.nl 

And 130 references on my training sessions can be found on: www.joriskersten.nl