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Cash and cash-like items: what's in a name?

Mark Ernots Mark Ernots

Enterprise value vs. Equity value

A buyer’s offered Enterprise value will typically be predicated on the following assumptions:

  1. The acquisition will be on a “cash-free and debt-free” basis; and
  2. The business will be acquired with a normal level of working capital.

This can be expressed as an Enterprise value to Equity value bridge, as shown below, which also illustrates the material impact these items can have on the final price:

From Enterprise value to Equity value

Enterprise value (€5 million x 8,0 multiple)   €40,0m
Plus free cash   €1,5m
Minus debts   (€7,5m)
Plus working capital on date of takeover €12,0m  
Minus normal level of working capital (€14,0m)  
Working capital adjustment   (€2,0m)
Equity value   €32,0m

The cash-free principle

To the extent there is cash in the business, it will usually trigger an upward adjustment to the equity value (unless the seller plans to extract it on completion). This adjustment enables the seller to benefit from the surplus cash still within the business, which has accumulated under its ownership.

In determining the basis of the cash adjustment, “cash” needs to be defined. In order for the seller to be fairly compensated for surplus cash left in the business, it will normally need to demonstrate that this is “free cash” as opposed to “trapped cash”.

The classification of cash items as “free cash” or “trapped cash” is subjective and depends on the specific characteristics of the business and the transaction.

Free cash will normally be adjusted for in the final equity value on a Euro for Euro basis, making it in a seller’s interest to negotiate for the maximum amount to be designated as free cash. Cash defined as trapped may be excluded from the equity value or it may be appropriate to redefine it as working capital.

Below are some examples of cash that might be considered by a buyer as trapped cash if they could not be readily extracted without harming the business: 

  • Cash in tills and petty cash
  • Cash in bank accounts held by foreign subsidiaries, in respect of which a restriction, ban or tax is applicable for the repatriation of the funds to the parent company
  • Cash where its distribution may be limited due to negative distributable reserves
  • Cash held as security or deposit, such as rental guarantees
  • Cash held on behalf of clients.

Conversely, in some cases items that are not ordinarily classified as cash on the balance sheet might be considered as “cash-like” for the purposes of the equity value adjustments. Some examples to consider are below:

  • Cash arising on exercise of share options
  • Unrealised capital gains related to real estate owned by the company
  • The value of assets held for sale
  • Tax losses carried forward.

There is no precise rule for how the above items should be treated and what value should be attributed to them. In assessing cash and trapped cash, consideration should be given to:

  • The basis of the headline enterprise value and whether the item has already been factored into the valuation
  • The likelihood and sustainability of a cash inflow to the business on or soon after completion
  • Whether the cash could theoretically be paid out via dividend, as it is not necessary for the cash to be held in the business in order for it to operate.