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Balance Sheet Approach to evaluate a firm
A balance sheet is made up of assets and liabilities and hence the balance sheet approach of evaluating a firm shows the values of the assets of a company.
Book Value of Assets is the Minimum Value of a Firm
When the values are un-adjusted, the balance sheet approach indicates the claims of investors over the assets of the company. That is, the book value of equity funds and debt funds represent the value of the firm the investors have ownership on. Therefore, the minimum value of a firm is equal to the book value of assets.
Value of a Firm is Worth More or Less than its Book Value
The book value of assets is just the raw value when we consider the unadjusted book value which changes due to depreciation and other factors. These factors may include changes in technology, inflation and earnings capacity. Therefore, the value of a firm is worth more or less than the book value of the firm.
For example, the non-operating assets have very little value or no value. Therefore, they must be considered having less value than the book value that is mentioned in the balance sheet.
On the other hand, there are some assets the value of which are quite higher than their book value. So, their replacement cost is much higher than the book value.
Revaluing the Assets and Liabilities of a Firm
Assets must be revalued to determine the value of a firm. One method of determining the value of a firm is to revalue the current assets and liabilities of a firm.
In one approach of evaluation of a company, to determine the adjusted book value, the current replacement cost is considered to be the real value of the assets. Thereby, the current or adjusted value of the assets is considered as the actual value of the assets.
It is relatively less complex to find the real value or the current cost of current assets. For example, the given amount of debtors may be adjusted for bad or doubtful debts while inventories may be valued at current costs after adjusting the redundant inventories.
When benchmark prices are at hand, it is also not quite hard to find the value of fixed assets like land and buildings. The difficult part is to find the value of plant or machinery because their prices change with the change in technology and use. This is especially applicable when there is no secondary market for plants and machinery. The services of valuers may be used in such circumstances.
To calculate the exact value of a firm, the factors such as brand value, customer loyalty and other intangible assets should also be considered. Therefore, valuing a firm depending only on balance sheet entries is not fully correct or all-inclusive.
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