Bad debts and what they mean for valuations

August 13, 2024

The economy is ticking up and growth is on the agenda so the risk profile of bad debts is changing.

Last week we talked about the intricacies of how stock value on a balance sheet can impact on company and share valuations.

Another area that needs close attention is the company’s debtor book.  Most of the companies we value have very good credit controls in place, but with an uptick in economic activity, trading volumes are likely to start increasing.  Companies wishing to take advantage of opportunities may start taking more risks in order to grow.  This may mean that they take on customers or offer payment terms where there is more intrinsic risk.  If invoices are not paid on time that can have very significant impacts on cashflow and profitability.  Valuation exercises must consider this issue.

A fast-growing company also needs to have the financial team in place that can help manage the financial aspects of that growth. Is a new and expensive FD required?  Does the credit control team need more resource?  Will a new accounting system have to be set up?  Will policies and procedures such as around purchase orders have to be written to manage invoicing credit control? This may mean more investment in staffing, which can have ramifications for cashflow and profitability too.  Understanding the particular situation helps us to decide whether adjustments to value are necessary through enhancements or impairments.

Often I am told that valuations work is an art or science.  I am convinced it is neither, its mathematics followed by arguments to justify the valuation especially around adjustments such as those mentioned above.

It’s the arguments, which need to be valid and justifiable (ideally back to academic or market or even fundamental research), that make each project so interesting.  No situation is unique and even day to day, the valuation of a private company and/or its shares can change.