Non-Cash Expenses
Our valuation system is highly accurate and easy to use, but there are a few data entries which require careful attention to detail. In order to ensure optimal valuation results for you and your clients, our newsletter will feature ongoing valuation tips such as this month’s topic involving non-cash expenses.
When going through the 7-Step process, it is important for the user to carefully read and understand the various intellitips which accompany each of the income statement and balance sheet entries in Steps 3, 4 and 5. These tips are accessible by hovering over the question mark to the left of each of the line items.
Some users may take advantage of the tips, but others may skip them entirely! We encourage new users to review all of the tips to ensure the most accurate results.
Non-Cash Expenses (Step 3, Line 5)
This particular entry is one that some users misinterpret based on their own understanding of what a non-cash expense might be. Within the context of business valuation in general and the BizEquity tool specifically, non-cash expenses are customarily ONLY depreciation expense and amortization expense. They are NOT expenses which are paid without cash, i.e. with a credit card or otherwise with credit.
A non-cash expense is an expense that is reported on the income statement of the current accounting period, but there was no related cash payment during the period. The most common example of a non-cash expense is depreciation - where the cost of an asset is spread out over time even though the cash expense occurred all at once. A fixed asset is often purchased for cash up front but the accounting recognition of the related expense is allocated over its useful life, e.g. 5 years, 7 years, etc.
The second most common non-cash expense is amortization expense, which again reflects the periodic cost of an asset which is spread out over time despite the fact that this asset was purchased with cash at one point in time. Just as fixed assets are depreciated, intangible assets are amortized.
The most common reason for amortization expense for small private firms is the historical acquisition of the subject company via an asset sale transaction. The IRS and GAAP require buyer and seller to allocate the purchase price of a business across multiple asset categories including goodwill (and other intangible assets like trade name, client base, covenant not to compete, etc.), which in turn is “amortized” over its useful life (which is 15 years for tax purposes but may differ for accounting purposes.)
Fixed assets are depreciated and intangible assets are amortized. In both cases, these expenses represent reductions in reported profits without a corresponding outflow of cash. For this reason and consistent with generally accepted valuation principles and procedures, non-cash charges are included in the important measure of owner-based company earnings known as discretionary earnings or adjusted cash flow. Accordingly, a proper entry for non-cash charges is essential in deriving an accurate, credible and defensible estimate of fair market value.
There are other examples of non-cash charges such as depletion expense for an oil or mineral development company or unrealized gains/losses, but depreciation and amortization expense represent more than 99% of all such entries into the BizEquity tool.
In the vast majority of cases, the lone entry for non-cash expenses will be depreciation expense as found on the first page of the tax return (and occasionally within cost of goods sold for manufacturing companies). Around 1 out of 5 companies will be associated with periodic amortization expense linked with intangible assets. While depreciation is found on page one of the tax return, amortization expense will typically be listed under “other deductions” on a Schedule in the back of the return.