Values a business under the assumption that the business has no debt (debt free) and no excess cash (cash free)
What is the Debt Free Cash Free Valuation Method?
Debt Free Cash Free (DFCF) Valuation method values a business under the assumption that the business has no debt (debt free) and no excess cash (cash free). In some sense, the debt free cash free valuation method ignores the target company’s financial components (debt and cash holdings) and looks only at its real components (assets).
Most mergers and acquisition deals are negotiated using some variant of the debt free cash free valuation method. It should be noted that there is no objective definition of excess debt and excess cash. They depend entirely on how the merging parties choose to define them. In fact, the classification of debt into excess debt and non-excess debt and the classification of cash into excess cash and non-excess cash is usually a very contentious part of the merger process.
Constituents of Cash
1. Physical cash in hand
It is the physical cash held by the business. It usually constitutes a very small portion of a business’s total cash holdings and is sometimes known as petty cash. It is usually divided into cash held in the currencies of countries in which the business operates in and in the currencies of countries in which the business does not operate in.
2. Cash held in banks
It is the cash held deposited by the business in checking and savings accounts at commercial banks. It is usually further divided into cash held in banks within countries in which the business operates in and cash held in banks within countries the business does not operate in.
3. Cash held in escrow accounts
It is the cash that the business expects to receive in the future from a past transaction.
Constituents of Debt
1. Bank loans
They refer to the money borrowed by the business from the bank. Bank loans are usually categorized as interest-bearing debt and are almost always categorized as excess debt.
2. Mortgages
They refer to all assets that the business might have used to secure funds from a lender. Because the debt free cash free valuation method looks at assets while valuing a business,mortgagesare also usually categorized as excess debt.
3. Uncashed cheques
They refer to all cheques written by the business that have not yet been cashed by their holders.
4. Outstandingcredit card payments
They refer to any money that the business has spent through a business credit card.
Excess vs. Non-Excess Cash
As mentioned above, there is no strict definition of excess debt or excess cash. Before the acquiring company can value the target company using a variation of the debt free cash free valuation approach, the two parties must decide on what exactly constitutes excess debt and excess cash.
For example, the target company may wish to treat cash in escrow accounts as excess cash whereas the acquiring company may wish to treat it as operating income and part of the business. Similarly, the target company may want to treat uncashed cheques as non-excess debt or debt that the acquiring company takes on whereas the acquiring company may wish to treat them as excess debt that the target company must pay off before the acquisition.
Advantages of Debt Free Cash Free Valuation Method
A debt free cash free valuation approach allows both the acquiring company and the target company to achieve a clearer picture of the acquisition. The acquirer knows exactly what it is getting from the transaction. Consider the following two situations:
- Company A wants to buy Company B. Company B has an existing market value of $100 million. However, Company B owes $120 million to its various debtors. The owners of company B sell the company to Company A for $80 million. However, Company A has just taken on $120 million of debt.
- Company A and Company C want to buy Company B. Company B is a cash-rich company ($20 million in excess cash) and has an existing market value of $100 million. Company A offers to buy Company B for $115 million, and Company C offers to buy Company B for $105 million. Company B chooses Company A on the basis of the higher offer only to realize that Company A treats the excess cash as operating cash that is part of the business whereas Company C treats the excess cash as excess cash.
A debt free cash free valuation approach helps avoid the situations described above.
Additional Resources
CFI offers the certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
- Idle Cash
- Senior and Subordinated Debt
- Unconventional Cash Flow
- Valuation Methods
- See all valuation resources
