What are the risk factors that are taken into consideration in a business valuation?

In AccuVal’s (a global leader in valuation, advisory and asset management services) most recent newsletter, the above question was asked. Here is their answer:

A: In addition to the appraisal approach, business risk, financial risk, and liquidity risk should also be considered.

Business risk is defined as the degree of uncertainty of realizing expected future returns of the business resulting from factor other than financial leverage. Business risk is applied to all factors that can have an effect on forecasted earnings, including any issue that may impact administrative and operating expenses, cost of sales, and sales. An appraiser takes into consideration the competition, industry, management focus, and working capital of that specific company.

Similar to the definition of business risk, financial risk is defined as the degree of uncertainty of realizing expected future returns of the business resulting from financial leverage. Financial risk pertains to interest expense. Interest expense can impact the pre-income tax earnings that were forecasted. Financial risk is company specific and is assessed on the asset base of the business. The level of financial risk varies. It can be considered minimal if business is primarily financed by equity. If financed by debt, however, the financial risk would most likely be considered medium to high.

Liquidity risk is industry specific, whereas business risk and financial risk are company specific. It is also not relative to the realization of some level of income. Liquidity risk relates to the uncertainty associated with the disposal of a closely-held business at fair market value. The uncertainty stems from the length of the disposition period as it relates to the time value of money.

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