Business Valuation of A Distressed Business

A distressed business refers to a company that is experiencing financial challenges such as declining revenues, negative cash flows, and high debt levels or facing bankruptcy. Business valuation of a distressed business requires a unique set of skills and methodologies to determine its worth. We will discuss the challenges involved in valuing a distressed business, the various approaches that can be used, and generally the most appropriate methodology.

Introduction to Distress:

Technically, there are two types of distress: Financial Distress and Economic Distress. Financial distress is tied to the capital structure and occurs when the business is unable to meet its debt obligations. Economic distress also occurs when the business is unable to pay its obligations (all liabilities), but mainly due to fundamental problems with its business strategy, cash conversion cycle, and/or business model. 

Why is a Distressed Business Challenging to Value?

Valuing a distressed business is particularly challenging due to the lack of profitability and uncertainty of future cash flows making it difficult to get a true picture of the company’s financial prospects. The company’s financial statements may also not accurately represent the current financial situation. Additionally, the company’s business model may be unstable or no longer viable, making it difficult to predict future earnings. Another complexity is when the business requires rescue financing or other financial intervention (such as restructuring) to remain a going concern. 

Approaches to Value a Distressed Business:

There are three primary approaches to valuing a distressed business: income-based, market-based, and cost-based.

1- Income-based Approach

The income-based approach is based on the Discounted Cash Flow (DCF) analysis to estimate the present value of future cash flows. This method requires estimating the cash flow of the company based on a business/value creation plan or financial intervention. The discount rate is adjusted to reflect the risk associated with the distressed business. The challenge with this approach is that the expected cash flows are often uncertain and based on several hypothetical assumptions, making it difficult to estimate the company’s worth accurately. 

The business plan may anticipate an increase in cash flow due to several strategic initiatives such as business model optimization, cost reduction, strategy alignment with the market, working capital efficiency, and operational streamlining. For example, a decrease in inventory levels (working capital) could free up cash that could be used to support business activities. Financial interventions are more complex and may require debt restructuring, conversion to equity, or additional investment by stakeholders. For instance, reorganizing the company’s debt might lead to reduced interest and principal payments, which would boost cash flows.

SDCF (Scenario DCF) analysis is a second variant of the income-based method. Under this approach, three scenarios of projections are prepared including a base case, a worst case, and a best case. After running DCF analysis, a probability is assigned to each scenario to arrive at the final valuation. 

2- Market-based Approach

The market-based approach involves comparing the distressed business with similar distressed companies in the same industry that have recently been sold. The multiples used in this approach are typically the Enterprise Value-to-Assets (EV/Assets) ratio, Enterprise value-to-Revenue (EV/Revenue) ratio, Enterprise Value-to-Capacity (EV/Capacity) ratio, and Price-to-Book value (P/BV) ratio.

The challenge with this approach is that finding similar companies to compare the distressed business can be difficult. Additionally, the market value of a distressed business may not be a true reflection of its worth due to the company’s unique financial challenges.

3- Cost-based Approach

The cost approach for valuing a distressed business involves estimating the cost of replacing the company’s assets or determining the liquidation value of the company. This approach may be more suitable for companies with tangible assets, such as real estate or plant & machinery.

Let’s use the example of a manufacturing company that is having financial problems to demonstrate the cost method for valuing a distressed business. The market value of the company’s assets has decreased as a consequence of its financial issues. We would estimate the cost of replacing the company’s assets to calculate the value of the business using the cost method. To account for the state of the market and the condition of the existing assets, the replacement cost would be modified. The modified cost might be less than the expected cost, for instance, if the estimated cost of replacing the machinery and equipment is $10 million but the current assets need $2 million in maintenance. In this case, the company’s liquidation worth would be $8 million.

It is significant to observe that the value of intangible assets, such as intellectual property or client relationships, may not be adequately captured by the cost approach. As a result, this method might not accurately depict the company’s total worth.

Conclusion

Valuing a distressed business is a complex process that requires a thorough understanding of the company’s financial situation, its business model, and the current market conditions. Generally, the most appropriate methodology for valuing a distressed business is the Scenario Discounted Cash Flow (SDCF) approach. This approach considers the possibility of various scenarios considering a business’s unique circumstances, such as the level of debt, operational challenges, and market conditions. More importantly, the SDCF approach presents a practical plan of action in terms of operational improvements or financial interventions which can potentially save a business from liquidation. If you are a distressed business looking for strategy consulting services, please click on the link to schedule a discussion.