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When the shareholders decide to sell a company, they want to know the fair market value of it. To get this estimate, you would have to put a price tag at all company’s assets and liabilities. Just a couple of specialists know how to evaluate company debts, and even fewer specialists know that debts a Company-creditor would get back from a Company-debtor have a market value, too. And this market value of the debt will be different from the balance value of the debt.

Finding the debt market value

Does a debt have a market value? Earlier I honestly thought that it doesn’t. Nowadays, many companies sell their debts to companies which specializes on selling debts because they don’t want to wait and want to get the money right now. This process is called factoring.

But in order to sell debts, companies need to know their current market value. This sounds challenging because there are no universal methods which determine the “right” value. So how shall we do it then?

To determine the value of corporate debts, it’s important to understand which parameters influence their value in the first place. A brief summary would look like this:

  1. Information about a debtor, his credit history and quality of management.
  2. Debtor’s financial statement.
  3. Analysis of operating profits, gross margin, and a revenue trend.
  4. The total debts amount.
  5. Any other obligations of debtors from the 3rd parties.
  6. If a debtor is ready to pay out all debts without going to the court.

These factors can also be divided into 3 categories: financial, non-financial and legal. In Europe, debts are represented by such financial instruments as futures, options, bills of exchange, obligations and swaps.

For example, in the Netherlands only the percentage rate is used which depends on the debt maturity. That is: till when the debt must be repaid in full. If a debtor postpones a payment along the way, the amount will be significantly increased. As a rule of thumb, a credit period rarely exceeds 60 days.

Debt calculation methods

There are two rate types for debt calculation:

  • Simple percent rate;
  • Complex percent rate.

If a creditor uses a simple percent rate, then it applies from the date when the debt was not paid out and till the date of pay out. Yet, the capital value remains unchanged.

If a complex percent rate applies, then the debt amount will be growing consistently.

When I consulted one Russian company on its debts restructuring, I had to review these methods and apply them within the Russian economic context. Some of them seemed to be too complex whereas some included irrelevant scenario analyses. Debt evaluation method, developed by Sergei Yudintsev, is considered the most extensive one as it includes multiple scenarios with all associated risks and factors of debt market value creation.

My 2-scenario method of debt appraisal incorporates the following steps:

  • Information revision and financial analysis of a debtor;
  • Discount rate calculation with an expert method;
  • Determination of amount to pay out based on 2 scenarios;
  • Calculation of weighted average amount;
  • Selection of a discount rate based on accounts receivables;
  • Calculation of the final market debt value.

Expert method includes summary discount rate with 0% risk and different risks.

                                      Re = Rf + Σ1-7

Risks which should be counted in while calculating a discount rate by expert method

Risks (S 1-7)  %
Management quality 0 – 5
Company size 0 – 5
Financial structure 0 – 5
Type of product and territorial diversification 0 – 5
Main clients 0 – 5
Current profit and its prognosis 0 – 5
Other risks like country risk etc. 0 – 5

Evaluate company debts

You should keep in mind that the Company can either pay its debt out or stop paying them out. That is, default on its debts. Therefore, there are just 2 scenarios for debt payouts.

  1. «Natural» scenario (S1) :

Normal case scenario, where

S — today value of discounted cash flow (a.k.a. total value;
S0 — fixed amount of debt;
R — discount rate;
T — turnover period of accounts receivable belonging to debtor (years).

Let me to notice that this formula has already included the inflation risk. This way, a conversion of old value into the new one takes place.

  1. Bankruptcy administration (S2) :

Bankruptcy scenario, where:

j — quantity of periods when  %  were applied per year;
n — discount period (years).

Since each case scenario carries a 50% chance of occurrence, we need to find the “S” average.

S average = ( S1 + S2 ) / 2

Often the Company’s accounts payable are exceeding accounts receivable. Companies-creditors with a high percentage of accounts receivable in their balance provide a trade credit (for example, the goods which are not paid by Company-debtor yet, payment postponing etc.)  to the debtor for shorter period. I assume this happens because crediting companies have already had their own debts.

To get the most accurate market value of a debt, we need to use a discount rate for the current situation of a Company-creditor. This is some kind of a trade discount which appears as a result of having own debts. The discount is determined based on several factors:

  • current debt market situation;
  • current financial situation of Company – debtor and Company – creditor;
  • period of postponing the credit;
  • loan maturity.

We can assume that if accounts payable are less than accounts receivable, then a discount rate should be 10-20%. If accounts payable are greater than accounts receivable, then a discount cannot exceed 10%.

The debt market value is valid for 3 months from the moment of debt appraisal. In terms of changing economics depreciation, the market debt value is increasing. That’s why a debt market valuation falls into a specific case in business valuation and requires close attention to select the right timing for determining the optimal debt market value.

The floor is yours…

Which methods did you use to estimate the market value of a debt? Can you recommend other ways? And how do you find the method described above? Let us know by sharing your thoughts in the comment section below.