Discuss other reasons for differences between the value of net assets recorded in the Financial Statements and the value which the firm may be worth.
Net assets are obtained by deducting a business entity’s total liabilities from its total assets (Vause, 2014). In ordinary businesses whose main goal is to generate profit (e.g. sole traders, partnerships, limited liability companies and so forth), net assets are more commonly referred to as shareholders’ equity (Carmichael & Graham, 2012, p.89). This is mainly because for-profit businesses can raise capital by getting shareholders to invest more resources in the form of equity; in exchange for their financial support, owners expect businesses to distribute higher dividends whilst improving their performance so as to increase their shareholder value (Carmichael & Graham, 2012, p.89; Helms, 2009, p.839).
Not-for-profit organisations, on the other hand, can only receive assets from donors, supporters, contributors and other providers who do not expect to receive any dividends or economic benefits in return. Since not-for-profit organisations do not distribute profits to any shareholders, their net worth is usually labelled as “net assets” rather than “shareholders’ equity” (Carmichael & Graham, 2012, p.89).
As Horngren et al. (2012, p.619) pointed out, shareholders’ equity (net assets) is a very important indicator that provides information about a business’ ownership structure and sources of assets. To be more precise, this item specifies how much equity derives from issued capital, i.e. capital invested by shareholders, and how much equity consists of retained profits, i.e. internally-generated profits that the business has decided to invest in future operations, rather than issuing higher dividends (Horngren et al., 2012, p.619). In view of these considerations, it is evident that net assets play a key role in either increasing or decreasing businesses’ overall value. In order to gain a better understanding of the impact that net assets have on firms’ value, suffice to say that when an entity’s net income rises, its net worth also goes up, so that if a new investor wants to acquire it, they will have to pay an amount that equals its net worth (Tracy, 2002, p.67). This amount would coincide with the business’ market value, which may be defined as the current value of an asset or a business and is obtained by multiplying the number of issued shares by the up-to-date share price (Damodaran, 2010, p.166).
Even though most analysts rely on market value weights to determine firms’ value, there are still many experts and practitioners who prefer using book value weights as they consider market value to be an excessively volatile indicator (Damodaran, 2010, p.166). In this regard, it should be noted that the book value of a firm’s equity coincides with its net assets – i.e. shareholders’ equity, net worth etc. – and can be recorded in financial statements only when past transactions and / or uncertain future events can be estimated accurately (Wahlen, Baginski & Bradshaw, 2014, p.530). Unlike market value, book value is not subject to significant fluctuations and the book value of both equity and debt can be easily extracted from firms’ financial statements (Damodaran, 2010, p.166). However, as stable and reliable as book value may be, it is unlikely to reflect the current value of a firm. That is why it is customary for accountants and analysts to estimate firms’ cost of capital using market value weights (Damodaran, 2010, p.166). As Damodaran (2010) pointed out, in developed markets, discrepancies between the book and market value of equity can lead to incorrect estimates (p.166).
In conclusion, while net assets can be used to evaluate firms’ worth on the basis of their shareholders’ initial investment and retained profits, market value is a more up-to-date indicator that takes into consideration current market conditions, thus enabling stakeholders to determine entities’ current worth.