Non-operating assets are, well, assets that are not necessary or appropriate for the normal operation of a business.  Non-operating assets come in a variety of forms, ranging from excess cash and cash equivalents, portfolios of marketable securities or bonds, investments in farms, ranches, housing developments, beach homes, airplanes, excess land from closed operations, apartment buildings, golf courses, and many more.

Treatment of Non-Operating Assets in Business Appraisals

In typical business valuations, appraisers will eliminate the income statement effect of non-operating assets, and then add the market value of the non-operating assets back to the equity enterprise value at the end of the appraisal.  For the value of an entire business, this treatment is as good as it gets.  If the business appraisal is for a nonmarketable minority interest, a variety of assumptions are required in order to discount them appropriately.

Even if you don’t think you have any non-operating assets on your balance sheet, continue reading.  Many closely held and family business have excess, non-operating assets and sometimes they are substantial in value.

For example, if a company owns a nice beach house in Florida that is used primarily for the benefit of its shareholders and their families, the costs of operating the beach house (interest expense if mortgaged, taxes, and all other expenses) would normally be subtracted from earnings in each year so that “normal” earnings can be analyzed. See my recent post on normalizing adjustments.

At the end of the appraisal, the non-operating assets are then added back, dollar-for-dollar.  With the beach house, it would be appropriate to obtain a real estate appraisal for the house so that the value of that non-operating asset could be added back to enterprise value.

5 Reasons NOT to Have Non-Operating Assets

For many years, I have been vocal when speaking to business owners and their advisers about the negative aspects of having non-operating assets on company balance sheets. The good reasons for not having non-operating assets on your balance sheet include:

1. Dampen Return on Equity.  Non-operating assets on the balance sheet require additional equity to support them.  Assume that Sample Company needs $10 million of equity capital to operate reasonably and earns $1.2 million per year.  The return on equity (ROE) is therefore 12%.  Now assume that same company has accumulated $2 million of excess cash that earns virtually nothing, and equity is now $12 million.  This company’s ROE falls to 10% and shareholder returns suffer.
2. Postpone Shareholder Returns.  The cash that Sample Company accumulated has not been paid to its shareholders in the form of dividends or economic distributions (i.e., distributions in excess of taxes for tax pass-through entities).  Sample Company is an S corporation, so the shareholders have already paid taxes on their portions of the $2 million of accumulated earnings that sit in cash balances.  If you were a shareholder of Sample Company, would you rather have your pro rata share of the $2 million excess cash or wonder what management and the board will do with it?  Would you rather have your return now, or would you rather wait to get the same dividend later?  My children all understood that ice cream today was better than the promise of ice cream in the future.  The same is true for the hypothetical $2 million dividend in this example.
3. Increase the Difficulty of Sale.  Excess assets can make the sale of a business more difficult in at least three ways.  First, if your company has an oddball asset and another, similar company does not, most purchasers would rather purchase the other company than have to address your oddball asset.  So you may miss otherwise good opportunities.  Second, excess assets that sit in working capital can create questions about the needed level of working capital for operations.   A purchaser looking at Sample Company’s working capital, which includes $2 million of what we know is excess cash, and argue that since it is part of the company’s normal operations, it is really a part of normal working capital that will transfer with the business.  You don’t want to have those discussions, and you won’t if you pay out the excess cash now.  It won’t be there to argue over later.  And third, excess assets may have dividend tax and/or depreciation recapture issues that make it difficult to get them out of a company at the time of sale.  Better to take care of those issues now so that you don’t have surprises later.
4. Distract from Management of the Business.  How can excess cash distract management?  One way is insidious in that management becomes “comfortable” having all that cash sitting on the balance sheet.  I’ve seen companies with lots of excess assets and comfortable managements too often for it to be rare.  That is why I’ve always advised paying dividends when reinvestment alternatives are not available.
5. Create the Temptation for Large-Ticket Purchases or Acquisitions.  The opposite tendency to getting comfortable is to get so focused on employing the cash in expansion or on an acquisition that the rest of the business suffers.  We have all read about companies who employed portions of their mountains of cash in ill-planned expansions or unworkable and risky acquisitions.  Again, I’ve seen this happen too many times for it to be rare.  So don’t create the temptation.  If you find the perfect acquisition, go to your shareholders or your bank, or both, to raise the needed capital.  If it is a good idea, the capital will likely be there.

Private Company Dividend Policy is the Throttle

How can companies avoid the accumulation of excess cash?  The answer lies in dividend policy.  Capital expenditures and debt repayment can be lumpy, so it is sometimes appropriate to accumulate cash in anticipation of such events.  But these are clear and understandable.  Over time, working capital requirements are reasonably determined for every company.  When working capital, and especially cash, rises beyond normal levels and there are insufficient attractive reinvestment opportunities, my suggestion is to pay out the potential accumulation before it accumulates.

Your company’s dividend policy determines the portion of your shareholders’ returns will be in the form of current dividend income and what portion will be deferred.  Your company’s dividend policy determines or helps influence the capital structure of your business.  And your company’s dividend policy has a direct influence on the rate of return that will be achieved by your shareholders on their investments in it.

Two of my most popular posts address dividends and dividend policy.  The introduction is here.  The second addresses seven critical things you need to know about your company’s dividend policy.

The bottom line to this post is that most of the reasons given by most companies for accumulating excess assets are really excuses.  I’ve provided five reasons not to accumulate excess, or non-operating assets.  The way to avoid excess asset creep is with a well-thought out and executed dividend policy.

If you have questions about this post or want to talk about any business or valuaton-related issue in confidence, give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time,

Chris