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Free CPD for law and accountancy: what is debt free cash free?
In this CPD module Financial Training Associates explains the role of debt free cash free values in the sale and purchase of businesses.
The material is of interest to accountants, lawyers, principals and other advisers dealing with the purchase and sale of businesses. A 10 question multi-choice interactive quiz follows the article. Lawyers, accountants or other professionals who have requirements to undertake a certain number of hours’ CPD (Continuing Professional Development) study each year may be able to credit the time they spend working through this material against their CPD obligations. This module is not explicitly accredited for CPD points with any particular professional body.
This article was written by a course trainer from Financial Training Associates and has been published by ACCA (the Association of Chartered Certified Accountants – the largest international professional body for accountants) in their member magazine and on their website.
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Debt free cash free
A letter written by a buyer offering to purchase a business might commonly contain the words: “this offer is made on a debt free cash free basis”. In this CPD module we:
- Explain what debt free cash free offers are;
- Provide some suggestions as to why they are used;
- Explain how debt free cash free offers are determined; and
- Compare debt free cash free to another term commonly used in finance: “enterprise value”.
Debt free cash free: what is it?
Imagine a typical business which had some amount of net debt (where net debt equals debt less cash). Imagine too a magnificent
benefactor or a fairy godmother who could work a wonder over the business and take away that net debt. Without those net liabilities,
magically, the business’s value would be higher. That’s the debt free cash free value: the value of the business if it didn’t have any net debt.
Debt free cash free vs. shares consideration
Let’s imagine a business with shares valued at 70 million. That’s the value on the right hand side of the chart below. Let’s imagine that the business had debt less cash or net debt of 30 million. The debt free cash free valuation would be 100 million. That’s the value on the left hand side.
For a business that has net debt (i.e. where debt is greater than cash) the debt free cash free value is higher than the value of the shares in the business. You can see that from the chart: the 100 million on the left is greater than the 70 million on the right. Working from left to right, if the owner of a business had received a debt free cash free offer of 100 million and net debt was 30 million, the owner would expect to receive 70 million consideration for the shares in the business.
Debt free cash free: why is it used?
Given that debt free cash free valuation differs from shares consideration, it’s easy for confusion to result. For example, a buyer’s offer letter might contain a debt free cash free offer of 100 million but, as shown above, that’s going to differ from the 70 million the seller expects to receive for the shares. Why is debt free cash free used at all? Here are some possible explanations:
- Comparability. Debt free cash free provides a common basis for comparing offers. Debt levels in a business will likely fluctuate up until the day the business is sold. By focussing on debt free cash free value we have a consistent way of measuring business value, irrespective of how debt levels fluctuate up until completion.
- It takes the purchaser’s perspective. The buyer of the business in the chart above is going to have to purchase the shares (e.g. for 70 million) and make sure banks are prepared to lend 30 million. The purchaser is responsible for making sure a total of 100 million of financing is in place. Debt free cash free takes the purchaser’s perspective: the 100 million of funding the buyer is responsible for.
- Deal inflation. Perhaps people working on deals would rather talk about higher numbers than lower numbers. An adviser might prefer to tell another potential client that they had just been working on a 100 million deal rather than a 70 million one. The business owner, after the deal is done, might prefer to tell their fellow golf club members that they have just sold their business in a 100 million deal!
- It’s a convention. We have already seen how debt free cash free value reconciles to shares value, with the bridge between the two being net debt. Because we can reconcile between the two, it doesn’t really matter where we start. Convention means debt free cash free is often used.
Debt free cash free and legal agreements for sale
Debt free cash free is really just a convention. Wherever you start, left or right, 100 million or 70 million, the two reconcile. There might be some people around the table who would rather talk about a big deal. Perhaps the adviser whose fee is a percentage of the deal size would rather talk about a 100 million deal. Perhaps the business owner would rather say they have just sold the business for 100 million.
In the actual legal agreement used for the deal, having a smaller deal size might help though. A lower number, such as 70 million, might be useful when it comes to calculating transaction taxes such as stamp duty or capital gains tax. To summarise, while offers are often presented on a debt free cash free basis, the actual legal agreement often contains a lower value.
Debt free cash free: how is it determined?
This is not a business valuation CPD module but, at the highest possible level, businesses are often valued by multiplying up earnings. A buyer might take a business’s earnings and multiply those to calculate the debt free cash free value used in their offer letter.
- EBITDA x multiple = DFCF value: Debt free cash free is the value of a business assuming banks’ claims were magically removed. Debt free cash free is the value of a business before we take account of the net liabilities owed to banks. To be consistent, when valuing a business by multiplying earnings, our valuation needs to utilise an earnings figure that also excludes banks’ claims, such as “earnings before interest, tax, depreciation and amortisation” (EBITDA – a pre-interest measure of earnings). The consistency here is that applying an appropriate multiple to pre-finance earnings (EBITDA) provides a valuation prior to banks’ claims on the business: the debt free cash free value.
- DFCF value minus net debt = shares value: In our chart we saw a route from debt free cash free to shares value which is what the seller expects to receive. We could subtract net debt to get from debt free cash free value to shares value (A above).
- Alternatively: NPAT x multiple = shares value. Alternatively, we could take a slightly different route straight to shares value by taking a post finance earnings figure like net profit after tax (NPAT), applying an appropriate multiple, and providing us with a valuation after banks’ claims on the business: the shares value (B above).
This is not a full valuation module but the very essentials are laid out above. The most important point is that EBITDA x a multiple = debt free cash free valuation. A buyer could conduct some research into values that other businesses had sold at or values other businesses were trading at in the stock market, obtaining a multiple for comparable companies. The buyer might then apply that multiple to EBITDA earnings for the comparable business and use that to help them decide what their debt free cash free offer should be.
The bridge between debt free cash free and shares value is net debt (see A above), although there is another way to get there too, as outlined in B above.
Debt free cash free and enterprise value
Those who have studied finance formally before will recognise the similarity between debt free cash free and another term used in finance: “enterprise value”. Both measures value the business excluding certain of its liabilities. This makes the two measures of value very similar. The difference is that some valuation practitioners would involve a few more liabilities in their calculation of enterprise value. For example, items that may not bear interest but still have to be financed, such as a pension liability. The two concepts are very similar.
Summary
To summarise, debt free cash free value:
- Represents the value of a business with net debt removed (remember the fairy godmother waving her wand over the business, magically removing those liabilities, increasing the value of the business);
- Is greater than shares value/ consideration for a business that has net debt (remember the 100 million against the 70 million);
- Is often used in letters offering to buy a business;
- Is very similar to another term used in finance: enterprise value.
This CPD article was written by a course trainer from Financial Training Associates Ltd. Most professionals who are in legal or accounting practice are required to complete a minimum number of hours of CPD training per year, with CPD requirements determined by their professional body. Law and accounting professionals are encouraged to assume responsibility for their own development and choose from a wide range activities relevant to their responsibilities and development needs. In some cases a proportion of the CPD requirement can be met through self study. Depending on the CPD requirements of your professional body, you may be able to credit the time spent reading this article and sitting the multi-choice test against your CPD obligations. This CPD module is not explicitly accredited for CPD points with any particular professional body.
For details of accredited CPD programmes run by FTA Ltd, please click here: