Customer Relationships explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
A generic IT services business with a loyal client base — the loyalty is the asset, and the attrition schedule is how it is measured.
Why this asset, and why this method
Ceva Infotech Ltd is a service provider for generic IT solutions. The Company relies on its well established and loyal customer base for a majority of its revenue. These Customers have been loyal to Ceva and the company also charges premium from other customers due to its good clientele. In such a case, the primary value driver for the Company will be its customer relationships. Without its customers, the Company would have been just another service provider for generic IT solutions with lower margins.
The value of Ceva's customer relationships can be best valued using MPEEM as most of the excess profits that the Company generates are on account of stability of revenue and lower customer acquisition costs accruing from its customer relationships.
Read the three lines of the schedule carefully, because their arithmetic is often misread.
The opening base runs 100.0%, 85.0%, 72.3%, 61.4%, 52.2%. The attrition line runs 15.0%, 12.8%, 10.8%, 9.2%, 7.8%. The closing base runs 85.0%, 72.3%, 61.4%, 52.2%, 44.4%.
The attrition rate is a constant 15 per cent of the surviving base — but expressed as a percentage of the original base it falls each year, because 15 per cent of a shrinking cohort is a shrinking number. That is why the second year's figure is 12.8% and not 15.0%.
The consequence is a decay curve, not a straight line. The base does not reach zero in six or seven years; it approaches zero asymptotically, which is why the remaining useful life must be cut off by judgement — here at five years, when 44.4 per cent still survives.
Note also that the margin rises from 10% to 12% after the second year, while the base falls. The two work against each other: EBIT is 34.00 in year 1, drops to 28.90 in year 2, then rises to 29.48 in year 3 as the higher margin takes effect, before resuming its decline. A valuation that assumed a flat margin would misstate the middle years in both directions.
And the contributory asset charges of INR 2 million are flat across all five years, unlike Illustration 12's percentage-of-revenue charge. A fixed charge against a declining earnings stream takes a progressively larger share — 8 per cent of earnings after taxes in year 1, but 13 per cent by year 5.
The computation
| INR Mn | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Opening | 100.0% | 85.0% | 72.3% | 61.4% | 52.2% |
| Attrition | 15.0% | 12.8% | 10.8% | 9.2% | 7.8% |
| Closing | 85.0% | 72.3% | 61.4% | 52.2% | 44.4% |
| Revenue attributable to customer | 340.0 | 289.0 | 245.7 | 208.8 | 177.5 |
| EBIT margin | 10% | 10% | 12% | 12% | 12% |
| EBIT | 34.00 | 28.90 | 29.48 | 25.06 | 21.30 |
| Less: Tax @ 25% | 8.50 | 7.23 | 7.37 | 6.26 | 5.32 |
| Earnings after taxes | 25.50 | 21.68 | 22.11 | 18.79 | 15.97 |
| Less: Contributory asset charges | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 |
| Net available excess earnings | 23.50 | 19.68 | 20.11 | 16.79 | 13.97 |
Net present value at a discount rate of 18 per cent: INR 61.05 million, ignoring the tax amortisation benefit.
Reading the result
The revenue attributable to customers starts at 340.0 — the base is applied to the closing position, not the opening one, giving 85 per cent of 400. That is the mid-period discipline in a different form: customers lost during year one do not contribute a full year of revenue.
The contributory asset charges arise on account of use of Fixed and Intangible Assets. Note what is absent: the customer relationships themselves are not charged, since they are the subject asset, and goodwill is excluded by rule.
Common mistakes valuing customer relationships
- Applying attrition to the original base each year instead of the surviving one.
- Holding the EBIT margin flat where the facts say it changes.
- Applying revenue to the opening base and overstating year one.
- Extending the forecast until the base reaches zero rather than fixing a useful life.