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Introduction to Financial Statement Analysis

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 What’s My Business Worth? – Part IV

This is Part IV in a series devoted to taking the mystery out of business valuation. In previous episodes, we covered some of the basic concepts of business valuation, and the three basic approaches to business valuation analysis. Then we introduced the concept of present value, and how to use discounting to value future cash flows.  In this episode, we introduce the concept of financial statement analysis.

This presentation contains general information about the valuation process, however it is not intended to give you advice about your own particular situation. You should always consult with your own advisors and should engage a qualified professional to assist in any valuation assessment.

You can watch our latest video presentation or read on your own below.

Table of Contents

Basis of Accounting
Levels of Assurance
Financial Statements
Ratio Analysis

What do we mean by Financial Statement Analysis?

So what do we mean by financial statement analysis? A company’s financial statements can tell us a lot about what is going on in the business. Beyond just looking at net income, we can get a feel for how effectively the company is using its assets. Is its capital structure optimal for the business? We can evaluate some of the financial risks that the company faces, and dig a bit deeper into profitability.

The better we understand a company’s financial statements, the more confidence we can have in future results. As an investor or buyer of the business, reducing uncertainty can give us confidence in making the investment or purchase.

Basis of Accounting

Before we can begin to analyze a company’s financial statements, we need to know the environment in which they were prepared. Financial statements of publicly traded companies in the U.S. must be audited by an independent public accountant, and must comply with the requirements of generally accepted accounting principles (GAAP) along with the rules and regulations of the Securities and Exchange Commission (SEC). Privately owned companies, however, have much more flexibility.

We need to know what basis of accounting was used in preparing the financial statements. Generally accepted accounting principles, often called GAPP, is the preferred basis of accounting. Preparing financial statements under GAPP will ensure that the financials are comparable from period to period, as well as to other companies. GAPP also requires comprehensive disclosure, via the footnotes, of information useful for understanding the financial statements.

Sometimes, we will see financial statements prepared on another basis. The income tax basis is fairly common for smaller privately-held companies. Some other bases could be Government GAPP, or International Financial Reporting Standards. Sometimes smaller entities will use the cash method of accounting. Under the cash method of accounting, sales are booked when cash is received. So if a sale was made on credit, we wouldn’t record it as a sale until the customer paid the invoice. Similarly, expenses are not recorded until they are actually paid.

Most importantly, we need to know whether the chosen accounting rules have been applied consistently for all statements. If the accounting is inconsistent, then our ability to learn anything from the financial statements is seriously limited.

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Levels of Assurance

Let’s take a minute to talk about what levels of assurance we might seek for financial information. The lowest level of assurance would be financial statements internally prepared by the company, with no outside oversight. While the financial statements may, in fact, be perfect, we would want to spend some time asking questions and looking at documentation to assure ourselves that the data is reliable. It would be advisable to seek expert advice here.

The next level would be financial statements compiled by an accountant. In a compilation engagement, the accountant would compile a company’s financial statements from the company’s own records.  The accountant would make inquiries of management, but would not perform any significant testing or analysis. The accountant would offer no assurance that there are no material misstatements or errors.  The accountant would issue a written report to accompany the financial statements.

The next level would be having the financial statements reviewed by an independent accountant.  In a review, the accountant would perform some limited testing and analysis, and would give limited assurance, in his written report, that the financial statements are presented under the requirements of the chosen basis of accounting.

The highest, and most expensive, form of assurance would be an audit. The auditor would express an opinion giving reasonable assurance that the financial statements are fairly presented under the requirements of the chosen basis of accounting. Due to the expense involved, audited financial statements are unusual for smaller privately-held companies.

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Financial Statements

The Balance Sheet

The Balance Sheet, or Statement of Financial Position, lists a company’s assets and liabilities, categorized. Assets are the resources of the company, and can include items such as cash, inventory, land, buildings and equipment.  The other side of the balance sheet describes how the assets are financed: liabilities represent amounts borrowed from others, and owner’s equity the amounts invested by the owners.  Generally, items are stated at historical cost, or at lower of cost or market values. We would have to read the notes to the financial statements to tell whether the company used any “mark to market” accounting.

Current assets are assets that will be consumed within one business cycle, typically one year. Current liabilities are obligations that must be satisfied within the same business cycle period. For the rest of this discussion, we will assume that the business cycle is one year. Current assets and current liabilities are often referred to as working capital, and current assets minus current liabilities as net working capital.

Fixed Assets other than land are depreciated. That is, a portion of its acquisition cost is written-off to expense each year.

We’ll refer to the example balance sheet, below, throughout our discussion of analysis techniques.

Figure-1

The Income Statement

The income statement, or statement of earnings, tells us about the company’s revenues and expenses, measured and recorded according to the adopted accounting rules. Income statements can be for any period of time: a month, a quarter or a year.  You will recall from our earlier discussions that net income is not the same thing as cash flow, it includes non-cash charges like depreciation expense.  Our example, below, is a comparative income statement for three years.  We’ll refer to it throughout our discussion of analytical techniques.

Figure 2

Statement of Cash Flows

The Statement of Cash Flows is probably the least understood, yet potentially most useful of the statements. In the top portion, operating activities, we see the effect on cash of variations in working capital items. If accounts receivable increased, for example, it means that some of the sales we reported on the income statement (included in net income) have not yet been collected in cash.

Cash flows from investing activities will show us when the company had capital expenditures, for example buying equipment.  Looking at the example, below, we can see that this company bought $12,000 in equipment during year 2011, and up in operating activities we see $2,000 in depreciation expense during the year. This corresponds with the $10,000 in equipment reported on the balance sheet at year-end 2011 ($12,000 purchase less $2,000 depreciation).

Cash flows from financing activities shows us the effect on cash of changes to the capital accounts of the business: specifically long-term debt and owner’s equity. We see that the owner put $2,500 into the business in year 2010, and borrowed $10,000 during 2011, with $2,000 repaid during 2012.

Figure 3

Notes to the Financial Statements

The notes to the financial statements, sometimes called the footnotes, are an integral part of the financial statements.  They will always be present in audited financial statements, but may sometimes be omitted, or highly condensed in unaudited statements.  If present, they should be read carefully.  In the notes, we will find the significant accounting policies of the enterprise, along with detailed disclosures of leases, long-term debt and other obligations, and fixed assets.

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Ratio Analysis

Up to now, we’ve covered the financial statements, and talked about determining the basis of accounting used to prepare them.  Now let’s look at some analytical techniques used to draw inferences about a company from its financial statements.

One of the most powerful tools to analyze financial data is ratio analysis. A ratio is just one number divided by another. It’s a way to compare results on a common basis. Probably the most familiar ratio we encounter is miles per gallon as a measure of fuel economy. If we were comparing two vehicles, and were told that vehicle #1 used 10 gallons to travel 200 miles and vehicle #2 used 5 gallons to travel 120 miles, it isn’t obvious which is more efficient. Be if we instead use the ratio of 20 m.p.g. for vehicle #1 and 24 m.p.g. for vehicle #2 we have a way to compare them.  Ratios serve the same purpose in finance: they provide a way to compare different companies using a common measure.

Liquidity

Probably the biggest risk a company faces is running out of cash. Cash, and other assets that can be quickly converted to cash (such as accounts receivable) are collectively referred to as liquid assets.  Liquidity ratios are a way to estimate the risk of a company being unable to meet its obligations over the next year. Liquidity ratios not only give us insight into the company under analysis, but can be compared with benchmarks and/or other companies.

The Current Ratio is defined as the company’s current assets divided by its current liabilities. You can think of it as an answer to the question,  do I have enough liquid assets to satisfy all of the obligations that would come due in the next year. As a rule of thumb this ratio should be greater than 1:1, although there are exceptions.  Referring back to the balance sheet of our example company, we calculate the current ratio for year 2012 as $11,794 / $2,650 = 4.5

The Acid Test ratio is a bit more conservative. It says, let’s assume that our accounts receivable and inventory are worthless, do we still have enough cash to pay all of our current liabilities. Again, this company is very liquid.  In 2012, the acid test ratio was $7,294 / $2,650 = 2.75

Liquidity should be evaluated in relative terms. While being highly liquid is safe, it could also indicate that cash and other assets are not being invested in a productive way. We have to look at high liquidity in relation to the strategic plan of the company: is it planning an expansion or being defensive against a new competitor, or is it overly cautious.

Accounts Receivable Ratios

Accounts receivable levels are an important indicator of the quality of the company’s customer base. A company may have high reported sales, but if it has trouble collecting payment it could eventually have a cash shortage.

Accounts Receivable turnover ratio

Accounts Receivable turnover ratio

The turnover ratio tells us how many times the receivable balance was “turned-over”, that is a sale made and collected, during the year. For example, if a company sold products on 30 day terms, we would expect a turnover ratio of 12 (365 days per year divided by 30 days terms). Looking at our example company we can see that turnover is improving.

Days sales in Receivables

Days sales in Receivables

Days Sales in receivables tells us how many days of sales are uncollected at the balance sheet date. It is simply the ending accounts receivable balance divided by the average daily sale.  If, upon inquiry, we discover that this company’s credit policy is to sell on 10 day terms, it would appear that it has a collection problem.  If credit terms are generally 30 days, then it appears collections are going very well.  The ratios have to be analyzed in context.

 Inventories

Inventory Turnover Ratio

Inventory Turnover Ratio

Inventory is often a material item on a company’s balance sheet. A significant risk is that obsolete or unsalable inventory is allowed to accumulate instead of being marked-down or written-off. Inventory turns, that is the cost of goods sold over a year divided by average inventory, gives us a feel for how long the inventory has been around.  Note the similarity with accounts receivable turnover, however we use cost of goods sold as the denominator as inventories are stated on the balance sheet at cost.

Inventory days on handSimilar to the days sales in receivable, days of inventory on hand is a way to evaluate inventory on hand in relation to the company’s sales. In our example company, we can see that at year-end 2012, at our current average daily sales, it would take us over 3 months to sell all of our inventory.

This seems like a lot of inventory, though it could be peculiar to the industry we are in, or be seasonal.  We would probably want to focus on inventories a bit more if we were considering buying this company.

 Coverage Ratios

Coverage ratios give us a way to compare earnings to the obligations of the company. They give us some perspective on the risk of financial leverage.

Interest Coverage Ratio

Interest Coverage Ratio

Interest Coverage Ratio, defined as net income divided by interest expense, helps us understand how much leeway there is before a company would be unable to meet its interest obligations. Lenders, in particular, are very interested (no pun intended) in interest coverage ratios. If we are contemplating buying a company with debt financing we would need to have some comfort on interest coverage.

Fixed Charge Coverage Ratio

Fixed Charge Coverage Ratio

The fixed charge coverage ratio is a bit more conservative, it uses all fixed charges, such as interest payments, debt repayments, leases, etc. as the denominator.  Our example company has shown significant improvement in 2012 compared to the prior year.  Fixed charge coverage ideally should be greater then 1.0 in most circumstances.

Profitability Ratios

Profitability ratios give us perspective on how much of a particular activity “falls to the bottom line”, that is how much results in profit.

Gross Margin

Gross Margin

Gross profit is a way to measure a company’s sales pricing compared with its cost of product. Gross profit is the difference between sales and cost of goods sold. If we divide gross profit by sales we call the result the gross profit percentage, sometimes referred to as gross margin. In our example above, 57% of each sales dollar was available to pay expenses in 2012.

Return on Sales

Return on Sales

Return on sales relates sales to net income, it is simply net income divided by sales. In 2012, we can see that just over 19% of each sales dollar was profit. This is an extraordinary result for most businesses. To be useful, though, we would need to compare these results with other companies in the same industry.

 

Return on Assets

Return on Assets

Another way to look at profitability is to relate it to either assets, or to the equity capital invested in the business. Return on assets, net income divided by average total assets, is often used to evaluate whether or not the company is productively using its assets. A low return on assets with an otherwise acceptable return on sales, for example, could lead us to investigate whether or not there were underutilized assets in the business that could be sold or invested elsewhere.

Return on Equity

Return on Equity

Return on Equity, sometimes called return on investment, is the company’s net income divided by the equity capital invested. In our example company above, the owner earned a 55% return on investment in this business. Return on equity should be considered in light of the company’s financial leverage, as we will see in a minute.

Financial Leverage

We’ve used the term financial leverage, let’s define it. First we need to define the term capital structure. Capital refers to the funds invested in a business to pay for its assets. Capital is typically comprised of debt and equity. Leverage refers to the relative amounts of debt and equity in the capital structure.

Like a conventional lever, we can magnify the results achieved by moving one side of the lever. Think of a see-saw, if the see-saw is evenly balanced then we can say there is zero leverage. A child on one side would remain forever in the air if an adult were on the other side. But if we unbalance the see-saw, that is, increase leverage, then the child on the long side can balance the adult on the short side.

It works the same way in finance. As we borrow more money, we need to invest less of our own money in the business. Note that leverage works both ways, however. It can magnify profits but it can also magnify losses, hence the risk.

Capitalization Ratios

Debt/Equity Ratio

Debt/Equity Ratio

The debt/equity ratio is a way to assess financial leverage. It is simply the company’s debt capital divided by its equity capital. If a company had no debt, its debt/equity ratio would be zero, and if it was financed equally with debt and equity its debt/equity ratio would be 1.0.

From our example balance sheets we can see that our company has been deleveraging during 2012, that is its debt/equity ratio has declined as it has repaid some debt, and its equity increased from earnings.

Effect of varying leverage on return on equity

Effect of varying leverage on return on equity

Here is an example of financial leverage. For this example, I assumed a company earns $20,000 before interest expense and has total capital of $100,000. With zero debt, the owner earns 20% on a $100,000 investment. As we increase debt, our net income declines (due to interest expense, which I assumed to be 5%) but our return on equity increases. With a debt equity ratio of 1, for example, net income is down to $17,500, but the owner only has $50,000 invested, so she earned 35% on her investment.

Summary

Some final thoughts. Financial statement analysis can be a useful tool to reduce the risk of buying or investing in a business.  Financial statement analysis gives us insight, but not necessarily definitive answers.  Analysis can help us focus attention where needed, and give us some assurance as well.

Its use is predicated on having accurate, consistently prepared financial information. If we are a business owner, one way to increase the value of our business is to ensure that we have reliable, timely financial information.

Financial statement analysis is a tool that can be used by an investor in evaluating a prospective investment, and also by a company’s owner or manager to pinpoint issues that require further attention.

I hope this has been informative. In previous episodes, we discussed some of the basic concepts behind valuation analysis, some of the methodologies used, and paid particular attention to the concept of present value and discounted cash flows. In this episode we introduced some of the concepts of financial statement analysis.

Stay tuned, We’ll continue to offer presentations that I hope will be useful for you. If I can offer any assistance, please feel free to contact me. Visit us on the web, or on Facebook. I would love to hear your comments, and any suggested topics for the next program

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Discounted Cash Flows Analysis

What’s My Business Worth? – Part III

This is Part III in a series devoted to taking the mystery out of business valuation. In previous episodes, we covered some of the basic concepts of business valuation, and the three basic approaches to business valuation analysis. In this episode, we are going to look at how we use discounted cash flow analysis to estimate the value of a future stream of cash flows.

This presentation contains general information about the valuation process, however it is not intended to give you advice about your own particular situation. You should always consult with your own advisors and should engage a qualified professional to assist in any valuation assessment.

You can watch our latest video presentation or read on your own below.

Time Value of Money (Present Value)

Common sense tells us that cash to be received sometime in the future is worth less than cash in your hand today. Why? It’s all about risk. There is the risk that you will never realize the expected future cash flow. Remember Wimpy? “I’ll gladly pay you on Tuesday for a hamburger today.” Unfortunately, he never specified which Tuesday.  Realization of that cash flow could only be described as “iffy.”

Anyone who has ever had a variable rate loan has experienced interest rate risk. As we will see in a minute, bond investors accept interest rate risk when they buy a bond. The value of their investment will fluctuate with market interest rates.

Opportunity cost is a way of saying that we have alternative uses for our cash: we could invest it in this opportunity, in another, sit on it, or spend it.

Discounting is the mathematical technique we use to measure and account for risk.

Example – Bond Valuation

A treasury bond is the classic example of a financial instrument with zero credit risk. Whether or not that is still true is beyond the scope of our discussion today, but let’s assume that it is. Let’s say we could buy a bond today for $10,000 that will mature in one year and repay our investment plus 5% interest. How much will we receive?   We will receive our original principal plus the interest earned on our investment.  The interest earned is simply our investment amount ($10,000) times the interest rate (.05)

Some Key Definitions:

  • Future value(FV) – is the amount we expect to receive sometime in the future.
  • Present value(PV) – the amount we will invest today to receive the future value.
  • Discount rate(R) – the implicit interest rate that we use to calculate present value

On to the math:

Finance, like physics, is really a field of applied mathematics.   I’ll try to keep the math as simple as possible, no more than high school algebra.

As we saw on our bond example earlier, the future value is the present value plus interest earned over the period of investment.  Expressed as an equation, FV = PV + I, where I = the interest earned over the period of investment.  The amount of interest earned in one period is equal to the interest rate times the principal amount of the investment. I = PV X R.

Substituting the PV times R for I in the first equation, we get FV = PV + (PV * R) which we can simplify to FV = PV X (1+R).

From our example, investing $10,000 at 5% for one year we get 10,000 * 1.05 = 10,500.  Looking at it the other way, the right to receive $10,500 in one year is worth $10,000 today.

Compounding Interest

Suppose we invested $10,000 earning 5% for 2 years?  Here we see the effect of compounding.

At the end of year 1, we have FV = PV X (1+R), which we re-invest for another year.  At the end of year two we would have earned interest on our re-investment amount giving us: (PV X (1+R)) X (1+R).

We can generalize the equation for compounding as follows: FV = PV X (1+R)^n where n is the number of compounding periods.  Dividing both sides of the equation by (1+r)^n, we solve for present value: PV = FV / (1+R)^n.

Using our treasury bond example, we expect to receive $11,025 in two years. The market interest rate is 5%, that is we would expect to receive 5% on a different investment with the same risk over the same term. Going through the calculation, you can see that the present value is our original $10,000.

  •  PV = FV / (1+R)^n where FV = $11,025, R = 0.05 and n = 2
  • PV = (11,025) / (1.05 X 1.05)
  • PV = 11025 / 1.025
  • PV = $10,000

Interest Risk Illustrated

Now let’s suppose we are looking at a bond that was sold with a coupon rate of 5% which will pay $11,025 in two years, but in today’s market similar investments are earning 6%. How much is this bond worth?

We perform the same calculation as before, using a 6% discount rate

  •  PV = FV / (1+R)^n where FV = $11,025, R = 0.06 and n = 2
  • PV = (11,025) / (1.06 X 1.06)
  • PV = 11025 / 1.1236
  • PV = $9,812

and arrive at a present value of $9,812. This says we could invest $9,812 for 2 years at 6% and will have $11,025 at the end, the same as this bond. Remember when we mentioned interest rate risk earlier? This is an example of interest rate risk. If we had paid $10,000 for this bond earlier, and wanted to sell it now it is only worth $9,812, the difference ($188) is due to interest rate fluctuations.

Selecting a Discount Rate

The choice of a discount rate is similar to the analysis we went through in the last program to select an earnings multiple.  It involves assessing operating risk, that is how much uncertainty surrounds earnings forecasts.  It also involves macroeconomic forecasts of future interest rates, and comparing with expected returns associated with alternative uses of investment funds.

There are a number of factors to consider in evaluating operational risk.  Let’s take a look at a few of them:

Revenues: Obviously revenues, or sales, is important, as revenues are the source of profits. Level of revenues is important, but we should also consider trends in revenues: is it growing year over year, stagnant, or declining? How does this company’s revenue levels compare with other, similar companies?

Predictability of Revenues: How likely is it that future revenues can be estimated based upon past revenue levels? If a company relies on a few, major customers, it is much riskier than a company that has a large, diverse customer base. The loss of even one major customer could change a profitable company into a loser. Repeat business, or business coming from referrals of past customers is an indicator of customer satisfaction with the company and its products or services. Looking at accounts receivable collection history can give us a perspective on the quality of customers. High bad-debt write-offs indicate a high-risk customer base. After all, a sale is only a sale when cash is received.

Earnings: When someone buys or invests in a business, what they really are buying is the future stream of cash flows or profits. We should look at profit margins, return on sales and return on investment, to evaluate the business performance and compare it with its peers. What are the trends in profits? A consistent trend of increasing profits would justify a lower discount rate than a level or declining profit trend.

Competitive Environment:  Understanding the competitive environment is critical to evaluating the risk to the company’s profit trend. How likely is it that a new competitor will enter the market? Are there any barriers to entry that would make it more difficult for a new competitor. Is there something unique about the business being evaluated. How does the company position its products or services? Is it a premium product, or a discount brand?

Reliance on the Owner: Does the company have written procedures and processes, or are they carried around in the owner’s head? Are customers and suppliers loyal to their relationship with the owner, or to the company’s products and services. Is there a management team in place to operate the business in the owner’s absence. Could a buyer expect that the owner will be cooperative during the transition? In a sale, is the owner willing to partially finance the deal?

Discounted Cash Flow Method:

There are four major steps in performing a discounted cash flow analysis:

  1. First we project future earnings, typically over 5 years but it could be longer or shorter.
  2. Estimate a selling price for the business at the end of the projection timeline.
  3. Determine an appropriate discount rate. The discount rate represents a risk-adjusted opportunity cost of capital for a prospective buyer or investor.
  4. Calculate the present value of the projected cash flow stream.

 Example Discounted Cash Flow Analysis

Figure 1

Let’s perform the four steps based on the data in Figure 1 above:

  1. We’ve prepared a five-year projection of earnings for our example company. In the first year, we expect $10,000, and we expect earnings to grow by 6% per year thereafter.
  2. Based upon forecasted year 5 earnings, we expect to sell the company at the end of year 5 for $34,719. The total cash received column is simply the yearly earnings added to the proceeds of sale.
  3. We have chosen a discount rate of 35%. As we discussed in our previous article, investment in a small business is significantly more risky than investing in the stock market, bond market, or real estate. The 35% is based on our best estimate for risks associated with the projected future cash flows.
  4. We then divide each year’s cash receipt by the discount rate to get the present value of that year’s cash flow. Note in year 2, the discount rate is 1.035 X 1.035.

We sum up the present values and arrive at a valuation estimate of  $31,934.

Summary

To summarize, expected cash flow in the future is less valuable than cash-in-hand today. We use discounting as a technique to estimate the value of expected future cash flows.  In the discounted cash flow method, we estimate future cash flows, and discount using a risk-adjusted discount rate to arrive at the present value.

I hope this has been informative.  In the next installment, we’ll cover financial statement analysis.  Then we’ll put it all together with a valuation analysis of an example company.

Cypress Business Partners offers a free estimate of the value of your business.  Please let us know how we can be of service to you.   Visit us on the web, or on Facebook.   If you would like to be informed when the next presentation is available, please send me your email address.  I promise to respect your privacy and will never share your information with anyone.

The Earnings Approach to Valuation

What’s My Business Worth? – Part II

This is Part II in a series devoted to taking the mystery out of business valuation. In our last installment, we talked about the 3 general approaches to estimating value: the asset approach, the market approach and the earnings approach. In this episode we will dig a little deeper into the earnings approach. The earnings or cash flow approach develops a financial model to estimate value. The underlying theory here is that the assets of the business, in total, are in place for the purpose of generating cash flow. Their collective value can be determined by looking at cash flow levels generated by those assets. We then ask, what a willing buyer would pay to take control over a stream of cash flows.

This presentation contains general information about the valuation process, however it is not intended to give you advice about your own particular situation. You should always consult with your own advisors and should engage a qualified professional to assist in any valuation assessment.

Net income is not the same thing as cash flow.

A Company’s net income is reported according to generally accepted accounting principles, and is not the same thing as cash flow. Net income reflects expenses, such as depreciation, that are non-cash: they represent a way to spread the recognition of a cash expenditure over a number of years. Net income is also dependent on the company’s capital structure. If a company has debt there will be interest expense. The form of organization dictates whether or not the entity has a provision for income taxes. If the company is organized as a “C” corporation under the tax code, there will be a provision for tax, whereas if the company is an “S” corporation or a partnership, the company does not pay tax: its taxable income flows-through the company onto the individual tax returns of its owners. The form of organization and capital structure of a company are based on what was most advantageous to its current owner.

If we are a prospective buyer of a company’s assets, we don’t care how the current owner organized his company, or how its assets were financed. We will make our own decisions regarding form or organization as is most advantageous to us. We will choose whether to finance the company with all equity, equity and debt, or all debt (if we can find a lender willing to do that.)

Earnings before interest, taxes, depreciation and amortization (EBITDA) is a way of looking at a company’s earnings irrespective of its form of entity and capital structure.

Let’s look at an example:

Table showing effect of capital structure and form of organization on reported net income.

Effect of Capital Structure and Form of Organization on reported Net Income

• Company A is a C Corporation (under the tax code). It reports and pays income taxes on its taxable income. Company A is financed with equity, it has no debt on the balance sheet.

• Company B is also a C Corporation, but its capital includes some debt, so it has interest expense.

• Company C is an S Corporation – for tax purposes it is a flow through entity. It pays no taxes, taxes are recognized by the shareholders on their individual tax returns. Company C also has some debt and pays interest. Note that if Company C had no debt, its net income would be the same as its operating income: $2,000.

Notice that all three companies have identical operating income, but their net incomes are quite different. Net income isn’t particularly helpful for valuing these companies. It seems that each company’s assets should be worth the same, but they show very different net incomes. Net income is skewed by the organization and capital structures of the current owners of the assets. That’s where EBITDA comes in.

Table calculating EBITDA from three companies with different capital structures and forms of organization.

Figure 2. EBITDA and Net Income

 Depreciation expense is non-cash, so we will add it back in all cases. We also add back interest and taxes for reasons we’ve already discussed, and we notice that EBITDA for all 3 companies is identical, as we would expect.

Owner’s Discretionary Income

We’ve already covered EBITDA, but let’s look at Owner’s Discretionary Income. We identify items included in operating expense that are either paid to the owner, or are paid at the owner’s discretion. An example would be the owner’s salary or a company car for the owner. Our intent is to calculate the cash flow that would be available to a new owner, or investor, to be paid-out of the business or retained in the business at the new owner’s discretion.

We add these items back to EBITDA to get ODI.

In summary, ODI can be thought of as the operating cash flow of a business available to be used at the owner’s discretion, regardless of form of organization and capital structure.

Estimating the value of a stream of cash flows:

Now that we have defined cash flow as ODI, we are ready to assign a value to ODI.  A company employs assets to generate cash flows. The Earnings Method says that the fair market value of the assets can be estimated by measuring the company’s cash flows, and then assigning a value to those cash flows. To a buyer, the value of a stream of cash flows is highly dependent on how much risk is perceived in attaining future earnings from the purchased assets.

One common method of estimating fair market value is to multiply earnings, for example owner’s discretionary income, by a multiple. We might use average ODI over several years, or the most recent.

The choice of a multiple is critical to this method. Defining the multiple requires professional judgment to evaluate the risk of investment. At first glance, the multiple seems to be an arbitrary number. In fact, the multiple is subjective, but hardly arbitrary.

So how does this method even make sense? Let’s take a look at some of the most important factors that should be considered.

Defining a Multiple

How do we go about deciding on an appropriate multiple? The multiple is another way of saying how risky does a buyer or investor perceive the company to be? Every investment involves risk, an investor would require a higher return to compensate for higher levels of risk. So how do we evaluate risk?

There are a number of factors to consider here, let’s take a look at a few of them:

Revenues:

Obviously revenues, or sales, is important, as revenues are the source of profits. Level of revenues is important, but we should also consider trends in revenues: is it growing year over year, stagnant, or declining? How does this company’s revenue levels compare with other, similar companies?

Stability of Revenues:

How confident are we that future revenues can be estimated by looking at current and past revenue levels? If a company relies on a few, major customers, it is much riskier than a company that has a large, diverse customer base. The loss of even one major customer could change a profitable company into a loser. Repeat business, or business coming from referrals of past customers is an indicator of customer satisfaction with the company and its products or services. Looking at accounts receivable collection history can give us a perspective on the quality of customers. High bad-debt write-offs indicate a high-risk customer base. After all, a sale is only a sale when cash is received.

Earnings (Cash Flow): 

When someone buys or invests in a business, what they really are buying is the future stream of cash flows or profits. We should look at profit margins, return on sales and return on investment, to evaluate the business performance and compare it with its peers. What are the trends in profits? A consistent trend of increasing profits would justify a higher multiple than a level or declining profit trend.

 Competition:

Understanding the competitive environment is critical to evaluating the risk to the company’s profit trend. How likely is it that a new competitor will enter the market? Are there any barriers to entry that would make it more difficult for a new competitor? Is there something unique about the business being evaluated? How does the company position its products or services? Is it a premium product, or a discount brand?

 Reliance on Current Owner:

Graphical presentation showing earnings multiple and return on investment.

Figure 3. Earnings Multiple and Return on Investment

Yet another factor to consider when setting a multiple is how reliant the business is on its owner. Does the company have written procedures and processes, or are they carried around in the owner’s head? Are customers and suppliers loyal to their relationship with the owner, or to the company’s products and services? Is there a management team in place to operate the business in the owner’s absence? Could a buyer expect that the owner will be cooperative during the transition? In a sale, is the owner willing to sign a non-compete agreement, offer training and help with transition, or partially finance the deal?

This chart illustrates how multiple is really a surrogate for return on investment. What the curve tells us is that as investors perceive more risk for an investment, they will demand a higher return on investment to compensate them for risking their money and time. One thing that jumps out is that ROI on this chart is considerably higher than what one could achieve in the stock market, the bond market or real estate. Ownership of privately-owned small to middle-market businesses is much more risky than most other investments. Publicly traded stocks and bonds are highly liquid, that is they can be sold on the public market almost instantaneously. Real estate, while less liquid, has historically been more stable in value. Small business is risky for a number of reasons. One, because it is illiquid, selling can take much longer and cost much more than selling stock or real estate.

Summary

To summarize, the Earnings approach states that the value of a company’s assets can be estimated by looking at the cash flows generated by those assets.

To measure cash flows, we would adjust reported net income for non-cash items, for expenses at the owner’s discretion, and for expenses related to the company’s form of organization and capital structure.

Since a prospective buyer is really buying future cash flows, we evaluate the risk that that current cash flows are not representative of future cash flows and calculate fair market value to compensate for perceived risk.

I hope this has been informative.  In the next installment, we’ll cover the concept of present value and discounted cash flow analysis, another way to apply the earnings approach.   Later, we’ll cover financial statement analysis.  Then we’ll put it all together with a valuation analysis of an example company.

Cypress Business Partners offers a free estimate of the value of your business.  Please let us know how we can be of service to you.   Visit us on the web, or on Facebook.   If you would like to be informed when the next presentation is available, please send me your email address.  I promise to respect your privacy and will never share your information with anyone.

Introduction to Valuation Analysis

What’s My Business Worth? – Part I

If you are a business owner, you are probably wondering what your business is worth.  Or perhaps you are an entrepreneur and are considering buying a business, what is a fair price?  Valuation analysis is a method to estimate the fair market value of a business. 

 In this series we are going to try to take some of the mystery out of valuation analysis.  In this first installment we are going to introduce some of the basic concepts of business valuation.  Our goal is to give you an overview of the valuation process and help you ask informed questions of your chosen valuation expert.   We are going to focus specifically on how we might go about valuing a privately-held company. 

This presentation contains general information about the valuation process.  It is not intended to give you advice about your own particular situation.  You should always consult with your own advisors and should engage a qualified professional to assist in any valuation assessment.  You can watch our presentation on video here, or read below.

What is a valuation report?

A valuation report is a defendable estimate, based upon established methodology, of the value of the business assets.

 Who might want a valuation report? 

  • A business owner, perhaps contemplating the sale of a business, to set expectations for pricing. 
  • An investor or buyer, would be interested in determining whether or not the asking price is consistent with the value of the purchase or investment. 
  • A lender would want to know that there is substantial value, and that the business is capable of generating enough cash flow to service the debt and also provide an income to the owner. 
  • A partner or shareholder in a private company, perhaps considering retirement or to settle a dispute. 
  • The IRS, to establish market value of a company to assess tax. 
  • Each of these potential users have a different perspective of the business’s value.

There could be several different value estimates, depending upon circumstances. 

Here are three of the most common.

  • Fair Market Value (FMV) is the value at which a willing buyer and seller would agree to exchange ownership of the business in an arms-length transaction.  Fair market value is an accepted measure under tax law and in most courts, and is the value generally used in a business setting. 
  • Replacement value is the cost to replace a particular asset, be it a piece of equipment, a building, or a company.  It may or may not reflect the fair market value, but in some circumstances, to settle an insurance claim for example, it may be the appropriate measure of value.
  • Liquidation value, is the value which a buyer would pay in a distressed sale, such as a bankruptcy. 

In most business settings, we will be focused on fair market value.  We are interested in how to price a business for sale.

There are 3 general approaches to estimating value:

  1. the asset approach,
  2. the market approach, and
  3. the earnings approach. 

In making a valuation assessment, the analyst would choose the approach that is most appropriate given the facts and circumstances of the situation.  Sometimes we might employ several, or all of the approaches to give us perspective, but in the end we will choose one as most appropriate.

  •  The asset approach attempts to appraise the assets of the business, both tangible and intangible assets.  The asset approach may be the most appropriate approach in some circumstances.  The value of a gold or precious gem dealer, for example, could be based more on the inventory value than on the ongoing business, but in most cases a going concern business is worth more than its assets alone.  Note that asset approach is not the same thing as book value, which is the historical cost recorded on the company’s balance sheet.
  • In a publicly traded company, we can easily compute the market capitalization of the company by multiplying the share price times the number of shares outstanding.  There is an established marketplace for ownership interests in publicly traded businesses.  Even here, however, the ultimate selling price per share for a controlling interest in a company could be worth more than its current price.  In a privately held or thinly traded company, it is not so simple.  There is no established share price.  We could look for recent sales of similar sized companies in the same industry.  The difficulty here is that most businesses are unique, we still need to make subjective adjustments to account for the differences between the example sales and the business under consideration, particularly looking at the circumstances of the example sale.  Was it between related parties, for example, or under duress?  
  • The earnings or cash flow approach develops a financial model to estimate value.  The underlying theory here is that the assets of the business, in total, are in place for the purpose of generating cash flow.  Their collective value can be determined by looking at cash flow levels generated by those assets.  We then estimate the value of the cash flow stream.  We will take a more detailed look at determining and valuing cash flows in the next installment.

Summary

 I hope this has been informative.  In this installment we covered some of the basic concepts of valuation analysis.  In the next episode, we’ll talk about some ways to put a value on earnings.   Later, we’ll cover financial statement analysis.  Then we’ll put it all together with a valuation analysis of an example company.

 Cypress Business Partners offers a free estimate of the value of your business.  Please let us know how we can be of service to you.   Visit us on the web, or on Facebook.   If you would like to be informed when the next presentation is available, please send me your email address.  I promise to respect your privacy and will never share your information with anyone.

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