Think Value

When evaluating an organization, it is important to correctly understand the pre-accrued expenses and corresponding reserves. Such expenses can be divided into four categories. Each requires a different approach.

I will analyze each one individually:

1. Current Pre-operational Expenses – e.g., warranty expenses These expenses, being operational in nature, should be normally deducted from revenues to determine NOPAT and should also be deducted from invested capital. In other words, they should be treated as net operational expenses and considered in operational cash flows (see Excel file).
2. Long-term Pre-operational Expenses – e.g., plant write-offs This refers to expenses that are long-term, one-time, and substantial. Examples include unfunded pension funds or plant decommissioning. In such cases, pre-reserves are created so that the profit and loss statement periodically absorbs them. Technically, the NPV of such expenses is calculated and recorded as both an asset and a liability (similar to a loan). The assets are written off through depreciation, while the liability part accrues virtual interest. At the end of the period, they are settled. For evaluation purposes, NOPAT is reduced by depreciation but not by interest expense. The current period liability is treated as equivalent to debt. After assessing the value of operational cash flows, this liability should be deducted to arrive at the share price, similar to any other debt (see Excel file).
3. Non-operational Pre-expenses – e.g., restructuring costs Organizations often plan for non-operational expenses and create pre-reserves for them. When such expenses are not part of regular operations, they should be transformed into cash flows. This means they should be planned as they will actually occur, and the reserves recorded on the balance sheet should be treated as equivalent to debt (see Excel file).
4. Profit Equalization Reserves Sometimes, reserves are created to stabilize the uneven profitability of financial statements (allowed in exceptional cases). For evaluation purposes, such reserves should be nullified, meaning they should be reversed. Accounts should be planned with real forecasts without reserves, and the reserves on the balance sheet should be treated as equivalent to equity (see Excel file).

EXCEL MODEL – Provisions

Source:
#VALUATION – Measuring and Managing the Value of Companies, 7th Edition
McKinsey & Company,
Tim Koller, Marc Goedhart, David Wessels