Why do we subtract cash when calculating enterprise value?
Shouldn't we be paying for the cash on hand too? If I am selling my company, why would I pay someone to take my excess cash?

Before we answer this question lets make sure understand what enterprise value is.

### What is enterprise value (EV)?

Enterprise Value is a metric that attempts to reflect the current value of a firm similar to other metrics i.e. market capitalization. However, unlike market capitalization, enterprise value is calculated with debt, cash and cash equivalents. This makes enterprise value a "truer metric" than market capitalization. Additionally, enterprise value is also used in used in standard valuation multiples such as Enterprise Value-to-EBITDA.

### Enterprise Value Formula

Enterprise value = market capitalization + debt - cash (cash equivalents)

Remember that market capitalization is shares outstanding x current stock price

### Explaining enterprise value

You are an investor and you want to buy a publicly traded company. After calculating the market capitalization you realize you can have a more complete picture of the company value. Before buying the company you take into account the potential expense of taking on said companies debt. Obviously, this debt is must be re payed to the lender eventually. However, this company also has some cash reserves. Those cash reserves can be used to pay down the debt mentioned earlier. The difference between cash and debt is then added to market capitalization to produce the enterprise value.

### enterprise value calculation example

So now that you understand the enterprise value let's take a look at a simple example of calculating EV.

Company A has a market cap of \$10 and it has \$5 in cash and \$2 in debt. You, the astute investor that you are, want to acquire Company A. Let's pretend you can buy all the shares at the current market cap of \$10.

So you bought the company for \$10. So far you've spent \$10. Still following?

Now you decide to pay down all of the debt, so you use \$2 in cash to pay down \$2 in debt. Since that cash money already resided in the corporation that you purchased, you didn't have to spend any more money out of your own pocket to pay down the debt. You've still spent just \$10.

Now you decide to pay yourself a dividend with the remaining \$3 in cash on the company's books. So you pay yourself a \$3 dividend. Let me add that you did all of this -- paying down the debt and paying the dividend -- on the same day that you bought the company. So now that you receive \$3 in cash, you can subtract that from your purchase price. \$10 - \$3 = \$7 (you can check this math on a calculator). So, your effective purchase price is Market Cap + Debt - Cash, or \$7.

Come up with your own simple way to apply this formula. You can throw around as many numbers as you'd like. To really anchor this idea down you have to have an intuitive understanding of the formula. If your still having trouble take a look at the video below.

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You're looking to calculate the VALUE of a company through EV. In broad terms, value of a company is assumed to be the present vale of its future cash flows. The excess cash on the books (not all cash is excess cash) is assumed to be a non-operating asset. It does not aid in generation of future cash flows and therefore does not contribute to value. That is why it is subtracted.

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Let's assume we have Company A and Company B, same Market cap and debt.

Only difference is Company A has 0 cash and Company B has \$500 million free cash.
Company B's enterprise value would be LOWER because we have to subtract out cash??

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The equity value of the company includes the cash on the company's balance sheet. So you need to subtract it or else you would be double counting it for EV.

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It is a non-operating asset, but also accounted for in the equity value...and really we're talking about subtracting excess cash, but it is usually assumed that cash balance is the excess cash.

Think about it from an acquisition perspective, the buyer would get the target company's cash as part of the deal, effectively lowering the price to acquire the firm.

To your point, you could have a negative EV in the case of a large cash balance (a bank, por ejemplo).

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Isnt debt free cash free relevant tho henceforth, cash is actually the sellers

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wouldn't debt be included in the balance sheet as well?

i just dont understand the logic of how it would be cheaper to acquire a firm with a billion cash versus a firm with no cash.

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Best Response

Think about it intuitively, what is EV?
EV is the price you have to pay to pay off every stakeholder (i.e. equity and debt holders).
Let's say you have company A with 1 \$ in equity, 10\$ in outstanding loans and 5\$ in cash.
So, you buy the company for 11\$ (1+11) and have 5\$ of cash left which you get to pocket, so you effectively only paid 6\$ (11-5).

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Basically EV is market cap + net debt

imagine paying 5 bucks for a 5 dollar bill, you're actually paying nothing.

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foreveralone:

imagine paying 5 bucks for a 5 dollar bill, you're actually paying nothing.

yeah but what i pay -\$5 for \$5

Its over complicated by definitions. My understanding is somebody buying out the firm buy both what the business owes to promoters( equity) and what it owes to creditors( debt). So assume i have to pay \$ 100 as cash to buy out both. Now when i do so the business is going to come to me with residual cash leftover. Say \$10. So i just deduct that and pay the net amount to buy out debt and equity.(\$90)

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god i hate accounting. this is why i became a trader ;[

Forever alone said imagine paying \$5 for \$5...

But we aren't paying for \$5. We are subtract \$5,.....

The cash you pocket would be used to pay off the debt. So the acquisition price (The EV) would be lower since you get a bunch of cash to use to help you pay off all the debt.

If I sell you a pencil and \$10 for \$15, what are you actually paying for the pencil? (hint- \$5)

That help?

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I agree with collegekid89 . suppose I just start a company that has only \$5 cash.
now the market cap will be \$5 and cash also \$5.

if we go by EV concept, it will have EV = 0. and we will pay 0 to get that company and get \$5 for free.

isn;t this wrong ?

ankit.agrawal:

I agree with collegekid89 . suppose I just start a company that has only \$5 cash.
now the market cap will be \$5 and cash also \$5.

if we go by EV concept, it will have EV = 0. and we will pay 0 to get that company and get \$5 for free.

isn;t this wrong ?

I have a lemonade stand except I don't have any lemonade or other assets. All I have is a \$5 bill. You come along and buy my "lemonade stand" for \$5. What is your net purchase price?

(It's \$0).

All I care about in life is accumulating bananas

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notamonkey:
ankit.agrawal:

I agree with collegekid89 . suppose I just start a company that has only \$5 cash.
now the market cap will be \$5 and cash also \$5.

if we go by EV concept, it will have EV = 0. and we will pay 0 to get that company and get \$5 for free.

isn;t this wrong ?

I have a lemonade stand except I don't have any lemonade or other assets. All I have is a \$5 bill. You come along and buy my "lemonade stand" for \$5. What is your net purchase price?

(It's \$0).

I got the point, but then while actual selling of the organization there should be some mechanism to freeze the cash or investment after the deal has been closed at a given price.

Yes you've found the flaw in the equation and can now profit hugely for it, go and buy apple for \$85bn less than its currently valued at, take the money out and sell it for \$85bn more, instantly worlds richest person.

cash is usually stripped out of a business when it is sold. it has no value beyond its face reserves, and is included elsewhere in the valuation.

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I thought I'd give this a go despite the prior valid explanations falling flat for our young apprentice:

Company A has a market cap of \$10 and it has \$5 in cash and \$2 in debt. You, the astute investor that you are, want to acquire Company A. Let's pretend you can buy all the shares at the current market cap of \$10.

So you bought the company for \$10. So far you've spent \$10. Still following?

Now you decide to pay down all of the debt, so you use \$2 in cash to pay down \$2 in debt. Since that cash money already resided in the corporation that you purchased, you didn't have to spend any more money out of your own pocket to pay down the debt. You've still spent just \$10.

Now you decide to pay yourself a dividend with the remaining \$3 in cash on the company's books. So you pay yourself a \$3 dividend. Let me add that you did all of this -- paying down the debt and paying the dividend -- on the same day that you bought the company. So now that you receive \$3 in cash, you can subtract that from your purchase price. \$10 - \$3 = \$7 (you can check this math on a calculator). So, your effective purchase price is Market Cap + Debt - Cash, or \$7.

All I care about in life is accumulating bananas

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notamonkey:

I thought I'd give this a go despite the prior valid explanations falling flat for our young apprentice:

Company A has a market cap of \$10 and it has \$5 in cash and \$2 in debt. You, the astute investor that you are, want to acquire Company A. Let's pretend you can buy all the shares at the current market cap of \$10.

So you bought the company for \$10. So far you've spent \$10. Still following?

Now you decide to pay down all of the debt, so you use \$2 in cash to pay down \$2 in debt. Since that cash money already resided in the corporation that you purchased, you didn't have to spend any more money out of your own pocket to pay down the debt. You've still spent just \$10.

Now you decide to pay yourself a dividend with the remaining \$3 in cash on the company's books. So you pay yourself a \$3 dividend. Let me add that you did all of this -- paying down the debt and paying the dividend -- on the same day that you bought the company. So now that you receive \$3 in cash, you can subtract that from your purchase price. \$10 - \$3 = \$7 (you can check this math on a calculator). So, your effective purchase price is Market Cap + Debt - Cash, or \$7.

just to clarify, paying down debt is rarely optional, it's a legal requirement baked into the debt contracts

What we are subtracting here is actually Excess Cash; however, we typically make the assumption that a company's cash balance equals excess cash. Excess cash has been reflected in equity value, and it belongs to Equity Holders. Based on the definition, excess cash is what remains after making payments to all other claimholders. The company will benefit from the excess cash because if they don't have excess cash, they may have a liquidity crisis in bad times, or may have to raise extra funds at higher costs. Investors will reward those companies that use Excess Cash well, thereby increasing its Market Value.

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Think of it as "Net Debt".

Say you have \$200M in Equity, \$100M in Debt, and \$50M in Cash. Therefore:

EV = \$200M of Equity + \$50M of Net Debt = \$250M
EV = \$200M + \$100M - \$50M = \$250M

@collegekid89 & @ankit.agarwal & rest-

I see this discussion has been on since 2011 - my shot at solving the same:

I agree with you that the EV will be "0" - but PLEASE REALISE WHAT WE PAY TO ACQUIRE IS EQUITY VALUE & NOT ENTERPRISE VALUE - so in Ankit's case, we will pay \$5 and in return will get \$5.

Coming to the question of why we deduct cash in EV, think like this - say you purchase a flat for \$2million and also need to service the balance debt against the flat of say \$3million; also in that flat there is \$1million lying around.

How much would you pay the owner? Ans. \$2million; but effectively you paid the owner 2m - 1m = 1m only, right? This is equity value.

How much did you pay for the ownership of the flat? you effective paid \$1m to owner and also assumed the \$3m debt, so \$4million - right? This is enterprise value.

So, reiterating my first line above, YES THE BUYER WOULD BE PAYING YOU FOR THE CASH LYING IN YOUR BOOKS - HE WOULD DO SO BY PAYING YOU (EQUITY HOLDER) FULL MARKET VALUE (which reflects the cash balance as well) - he will be paying you MARKET VALUE and NOT ENTERPRISE VALUE.

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Is there a difference between cash treatment when calculating EV through FCFF Vs. the EV computed through the trading data available for a listed firm?
eg. FCFF will only value operating assets so you'll need to add excess cash (i.e. non operating assets) to equate it to the EV the stock trade is valuing it at. Is this correct?

Hopefully this can help collegekid89 three years later...

Lets NOT subtract the cash and see what happens

A company has \$5 combined (equity + debt) and then \$500 million in excess cash. So you buy the company for \$500,000,005. Now you have \$500 million in cash lying around. Subtract that from the amount you paid for the company and in reality you only paid \$5 for the company.

I've read through this entire thing, and it seems like the OP mistakenly considered EV as the purchase price. I thought the same thing too, but I've now learned.

The purchase price is essentially the equity value (market cap), then you won the company. But you have to pay the debt, so you include this in the price. That's it, the price of a company is essentially equity value plus debt since you can't avoid it. Now you won the company. You get its cash too (excess, if any after paying debt) - this offsets against your purchase price, reducing the amount effectively paid, giving you the EV. Think of both debt and cash a part of Equity value, which includes everything.

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+1 SB. Thanks for clearing it up for me.

Wow. This thread went surprisingly well. Sure hope that kid eventually got it...

"When you stop striving for perfection, you might as well be dead."

I came here myself to clarify because I keep getting things mixed up, but hearing so many different variations of explanations has cemented the understanding of EV in my mind.

Good thing we have forums like this!

Enterprise value is not a valuation metric per say. It is the all in price to take complete control of the company. You need to buy out everyone that has any interest in the company. All of its shareholders and all of its creditors.

You buy a house for 10 and there's 2 dollars in the living room. The all in cost is 8.

You buy a house for 10 and there's a lien against it for 5. The all in cost is 15.

A company with more debt is more expensive to take over. A company with cash is cheaper to take over.

As a buyer, ceteris parabus you would rather a lower EV the same way you would rather buy the cheaper of two identical houses.

Not ceteris parabus, I would assume a higher EV company is more valuable than a lower EV company the same way I would assume a more expensive house is a better house.

Hi
At first, EV is roughly equal to Equity+Net Debt.
Net debt = Gross debt (including bank overdraft) - cash and cash equivalent (by coherence, opposite of bank overdraft)
So the available cash is deducted from debts. When there is too much cash, net debt can become negative, and therefore EV<equity value.
As it was said, when you buy a company, you pay the share price. So you pay equity (roughly).
Then : if company has got \$5M cash in its balance sheet, you pay the same price as you pay equity (only net debt is changed by this data). Which means you pay higher than what the firm is worth. But finally you get back your \$5M cash of excessive payment via \$5M available cash in the balance sheet, that you own as a shareholder. In other word, available cash doesn't influence the price of equity value.
Also, cash and cash equivalents doesn't help you earn cashflows and therefore when you use a DCF method, it is coherent to reduce it from EV to get the equity value.
Finally, it is nowadays a non-sense to have an important amount of unushed cash and a negative net debt.

Hope it helps,
Regards.

Think of it as if you were considering the enterprise value of a wallet. If the wallet was full of USD 100 bills, you would exclude them when valuing the wallet itself, because it does not add any inforamtion (it doesn't tell you if it is cheap or not, it is just a distraction).
The EV is the price of just the wallet, whether you paid for it with equity or with debt. The cash it contains is excluded because it does not add information (cash would include not only USD bills but forex bills, bouchers and other things with high "moneyness")

If I'm selling you my company for \$100k and including \$20k of cash with it when it's sold, this is the same as selling it for \$80k and taking the cash out before selling.

Or an easier explaination. Since debt is a component of enterprise value. You subtract cash because cash can be used to be pay off the debts

Basically EV = equity value + net debt

Enterprise value represents the value being assigned to the *operations* of the business, whereas ownership of the business takes into account the value of holding non-operating assets. Let's say we have a restaurant which produces \$100 of cash flow per year (no debt) and will do so forever, at a 10% discount rate that stream of cash flows from the business is worth \$1,000.

However, this restaurant has \$200 in cash and some other excess assets worth \$100. The value of owning the business is then \$1,300. So if this company traded publicly, you'd see the price of the shares as \$1,300, or 13x cash flow. But the market isn't actually valuing the business at 13x cash flow - it's valuing it at only 10x cash flow, then adding in the value of the assets you would own if you bought the business but aren't required to operate it. The market cap of a company which you observe should reflect the value of the business itself as well as any other assets that come along for the ride.

If you think about it intuitively like this I think it should make sense. You'll also realize that by cash, in theory we mean excess cash, because some level of cash is actually required to run the business day-to-day. Also, you wouldn't just subtract cash, you would subtract any assets the firm owns but aren't required to run the business.

dk24 - think your question should read 'why do you subtract cash from enterprise value WHEN MOVING FROM equity value TO ENTERPRISE VALUE'

Few definitions:
-Enterprise value = value regardless of capital structure
-equity value = value to equity holders, who own all of the cash

Thus, when moving from equity value to enterprise value, cash is subtracted, b/c enterprise value is independent of capital structure (as mentioned above). Point is to keep in mind that cash has already been added to equity value

Does this make sense?

Ok, so the way i see it, in very very simple terms and conditions: equity value is what you would pay to shareholders to own the firm. EV is what are you effectively paying, not the amount you would give to shareholders (because you also have to pay debt that's why you add it).

If you wanted to buy a \$5000 car from a friend who also had \$5000 cash, would you spend \$5000 to buy the car or \$10,000 to buy both the car and his cash?

Given that Enterprise Value is not exactly the price paid by an acquirer, but rather the total value of the operations of a firm, we subtract Excess Cash and all other Non-Operating Assets because:

as the definition of Enterprise Value says, we are valuing only Operating Assets; Excess Cash is not an Operating Asset and is implicitly accounted for in the Equity Value; therefore, we need to subtract it (together with all other Non-Operating Assets) when calculating Enterprise Value.

The reason therefore is not because we assume to pay off debt with it (the concept of net debt), since not all debt can be retired prior to maturity and since, if it can be retired, this will usually include prepayment fees (thus cash cannot be netted against debt). This assumption is conceptually and mathematically wrong.

With regards to the price paid by the acquirer, this usually has as a floor the Equity Value. Debt is added to the purchase price only if it is refinanced (take out new debt and repay the old one) or paid off by the buyer (with his own cash). If, instead, the buyer decides to assume (keep) the debt, this will not add up to the effective payment. Additionally, we should include potential premiums, transaction fees, unfunded pensions, capital leases, debt repayment fees etc. Also, unlike in the EV calculation where we take out all Non-Operating Assets, we should subtract only Cash from the purchase price (since we are paying cash with cash). Obviously, we have to pay for the other Non-Operating Assets such as properties, investments etc.

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