Retail Home-Decorating Business Balance Sheet Reconstructed for ValuationRecast 1992 Current Assets Property & Equipment Retail Home-Decorating Business Reconstructed Income Statements..
Trang 1Retail Home-Decorating Business Balance Sheet Reconstructed for Valuation
Recast 1992 Current Assets
Property & Equipment
Retail Home-Decorating Business Reconstructed Income Statements
Trang 2Brief Case Background 141
Retail Home-Decorating Business
Balance Sheet
1992 Current Assets
Property & Equipment
Trang 3Stockholder Equity
Retail Home-Decorating Business Detail Reconstructed Income Statements
Trang 4Note: This table adds minimally to the analysis section here; however, it is included primarily to show that sales and expenses comprise many items, some of which can seasonally offset the seasonability of other items In this respect, it will help point out that items as they may appear
in ‘‘total’’ on many income statements can lead to inaccurate conclusions in forecasting, until one assesses the contribution each item makes.
Financial Analysis
This business presents a number of issues that should be of concern to thevalue processor Sales appear to have reached a plateau and, in fact, arewaning Gross profits, however, seem tightly woven to sales in each of thethree years Recast income reveals that the business took quite a hit in
1991, sinking from $241,870 to $186,315, while sales remained tially the same Without rentals, cash flow is quite subdued Forty-sevenpercent of the $55,555 hit came in the way of increased wages and 37%through increased sales promotion expenses and utilities Sales promotionwas a onetime write-off of derelict items, and utilities contained $9,000
essen-of onetime construction expenses Labor, however, was considered essary to sustain sales and was considered partially justified by an offset of
Trang 5nec-lower commissions The owner expressed satisfaction in the level of 1992expenses in relationship to either 1991 or 1992 sales At this point, wecould either reconstruct 1991 expenses to reflect the reduction of extraor-dinary cost or simply accept the 1992 column as being indicative of anappropriate cash stream to value In light of the owner’s earlier remarksthat his business had peaked out at this location, we might accept thispremise and proceed with the analysis Also, in making this assumption,
we would not ordinarily calculate a weighted average cash stream
Ratio Study
Financial experts will not always agree as to which ratios are particularlygermane to the small and privately owned enterprise I feel that it is es-sential to examine the following
This ratio measures the percentage of sales dollars left after cost ofgoods sold (sometimes referred to as cost of sales) are deducted Thesignificant trend in our retail company is for acceptable efficiency of theselling process; however, in calculating this ratio we need to assure our-selves that we included ‘‘apples’’ in our cost of goods that are comparable
to ‘‘apples’’ in the cost of goods in surveyed samples Thus it is important
to explore the survey’s definition of items included in cost of goods andperhaps even restructure the target company’s statements to reflect same-case scenarios
It should be noted that ratios for net profit, before and after taxes, can
be most useful ratios But the fact that private owners frequently managetheir businesses to ‘‘minimize’’ the bottom line will often produce littlemeaningful information from these ratios applied to smaller businesses.Therefore, these ratios are not included Balance sheet data necessary forcalculating certain ratios for 1990 and 1991 are not included in the text;however, I have presented the ratios in those categories affected to com-plete the range of values
The current ratio provides a rough indication of a company’s ability to
Trang 6Financial Analysis 145
service its obligations due within one year Progressively higher ratios nify increasing ability to service short-term obligations Bear in mind thatliquidity in a specific business is an element of asset composition Thus,the ‘‘acid test’’ ratio that follows is perhaps a better indicator of liquidityoverall In this particular business, we must note that $92,155 of currentassets are sales promotion devices that are unlikely to be turned back intocash per se
sig-Total Current Assets
Total Current Liabilities
Industry Median
Note: Unreconstructed balance sheet used.
The quick, or acid test, ratio is a refinement of the current ratio andmore thoroughly measures liquid assets of cash and accounts receivable
in the sense of ability to pay off current obligations Higher ratios indicategreater liquidity as a general rule
Cash and Equivalents Ⳮ Receivables
Total Current Liabilities
Industry Median
(Income Statement) Sales
Sales/Receivable Ratio ⳱ or
Receivables (Balance Sheet)
Trang 71990 1991 1992
Industry Median
This is an important ratio and measures the number of times that ceivables turn over during the year Our target company seems to turnthese over in tune with the industry median
This highlights the average time in terms of days that receivables areoutstanding Generally, the longer that receivables are outstanding, thegreater the chance that they may not be collectible Slow-turnover ac-counts merit individual examination for conditions of cause In our caseexample, three years show inconsistency in collections although they dofall within the industry median range
Note: Cost of sales and cost of goods sold are interchangeable terms.
Generally, the higher their turnover rate, the shorter the time betweenpurchase and payment Lower turnover suggests that the company mayfrequently pay bills from daily in-store cash receipts due to slower receiv-able collections This practice can be somewhat misguided in light of in-vestment principles whereby one normally attempts to match collectionsrelatively close to payments so that more business income can be directedinto the pockets of owners Some businesses may, however, have littlechoice
Sales
Sales/Working Capital Ratio ⳱ or
Working Capital
Trang 8Financial Analysis 147
Industry Median
Note: Current assets less current liabilities equals working capital.
A low ratio may indicate an inefficient use of working capital, whereas
a very high ratio often signals a vulnerable position for creditors Ourtarget company has been below the median and may increasingly be grow-ing inefficient in the use of its working capital
To analyze how well inventory is being managed, the cost of sales toinventory ratio can identify important potential shortsightedness
A higher inventory turnover can signify a more liquid position and/orbetter skills at marketing, whereas a lower turnover of inventory may in-dicate shortages of merchandise for sale, overstocking, or obsolescence ininventory Our case example falls into the lower quartile as regards inven-tory management This should signal the need for a particular examination
of inventory as to quality and size
Conclusions
Financial analysis does not conclude with ratio study, but for our purpose
it will suffice Sales have been flat, the owner losing interest, and perhapshis territory ‘‘maxed’’ out If his assessment for growth is accurate, thevalue of his business is to be found in the history up to 1992 Growth byway of new product development or new locations can be costly growth.Certainly the values in these ideas belong to the person who pays for andexecutes them, and maintaining present levels in sales may take more thanjust labors of love This case exhibits conditions where the use of ‘‘dis-
counted’’ processes may be least likely to produce satisfactory results.
Trang 9The Valuation Exercise
Book Value Method
Total Assets at Year-End 1992 $968,340
Adjusted Book Value Method
Assets
Balance Sheet Cost
Fair Market Value
1 While sample material may have little resale value, promotional devices are necessary to generate sales Subsequently, when the business is sold as a ‘‘going concern,’’ these items can be included
at book value I caution, however; sales promotion items can experience very short life spans, particularly in a home decorating business where styles change rapidly.
2 Stated at appraised and, thus, fair market value.
Hybrid Method
(This is a form of the capitalization method.)
1⳱ High amount of dollars in assets and low-risk business venture
2⳱ Medium amount of dollars in assets and medium-risk business
venture
3⳱ Low amount of dollars in assets and high-risk business venture
Trang 10The Valuation Exercise 149
Yield on Risk-Free Investments Such as
Risk Premium on Nonmanagerial Investments a
Risk Premium on Personal Management a 7.5% 14.5% 22.5%
Excess Earnings Method
(This method considers cash flow and values in hard assets, estimates tangible values, and superimposes tax considerations and financing struc-tures to prove the most-likely equation.)
Net Cash Stream to Be Valued $ 171,935
Cost of Money
Market Value of Tangible Assets, Minus Liabilities 1
(see reconstructed balance sheet) $1,051,465
Trang 11Excess of Cost of Earnings
Return Net Cash Stream to Be Valued $ 171,935
Intangible Business Value
Times: Intangible Net Multiplier Assigned ⳯2.5*
TOTAL BUSINESS VALUE (Prior to Proof) $1,218,435
(Say $1,220,000) Financing Rationale
1 Minus liabilities whenever liabilities are sold with business.
*Refer to Figure 9.1 ‘‘Guide to Selecting Net Multipliers,’’ in Chapter 9.
At this point, we must gauge the amount in prospective bank financing.It’s important to use a good deal of logic at this stage of valuation or youwill waste a lot of time coming up with reliable estimates One can set upthe financing scenario any way appropriate to the local conditions, but myguess is that the following would be pretty close
(Say $590,000)
*Bankers often calculate a strange configuration when real estate that has separate cash flow is included in business financing Noting the reconstructed income statements, rental income equals
$75,750 in 1992 70% of $75,750 equals $53,025 and annual payments of principal and interest
on $460,000 of debt equals $53,269 Neat little ‘‘cushion,’’ wouldn’t you say?
I must interrupt the process flow for a moment to remind readers thatreal estate sold with a ‘‘going concern’’ should be treated just as all other
assets for the purpose of business valuation Unless, of course, intangible
business value in the foregoing calculation is ‘‘0’’ or a negative number
In that case, there is no business value to report in excess of the values in
hard assets, including real estate Such being exhibited translates into
Trang 12The Valuation Exercise 151
assets-only for sale, and, subsequently, appraisal of assets versus businessvaluation would be the assignment undertaken However, one should notneglect a possibility that real estate could be leased rather than sold Inour example, real estate enjoys strong cash flows and could remain anexcellent investment for the previous business owner In this event, busi-ness value would be examined without the real estate asset, expenses in-creased to include ‘‘rent’’ paid, and the rental income removed fromreconstructed cash flows So many years using the ‘‘excess’’ method havetaught me the ‘‘gut-feel’’ as to which way to initially proceed When in
doubt, I start as I have here, because a facility is necessary to conduct
business, and one way or the other, there will be a cost associated withhousing The formula walks me into examining the correct pew I mustultimately consider In spite of what I’ve just said, real estate and otherhard assets will always have ‘‘stand-alone values.’’ These must be known
to the best of your ability, regardless of the strengths or weaknesses ofbusiness cash flow Business-value estimating that portends to depress fairmarket values of real estate and other hard assets is irresponsible reporting
Bank (10% ⳯ 20 years)
Annual Principal/Interest Payment 68,324
Testing Estimated Business Value
Return: Net Cash Stream to Be Valued $171,935
Less: Annual Bank Debt Service (P&I) ⳮ 68,324
Less: Est Dep & Amortization (Let’s Assume) ⳮ 33,930
Less: Estimated Income Taxes (Let’s Assume) ⳮ 1,600
Net Operating Income (NOI) $ 79,781
*Debt service includes an average $11,700 annual principal payment that is traditionally recorded
on the balance sheet as a reduction in debt owed This feature recognizes that the ‘‘owned equity’’
in the business increases by this average amount each year.
Return on Equity:
Pretax Equity Income $115,311
Return on Total Investment:
Net Operating Income $ 79,781
Total Investment $1,120,000
Trang 13Although return on total investment is abysmally low in relationship toconventionally expected investment returns, the return on equity is at-tractively high and cash flow is strong.
a deal If we leave the price at $1,220,000, either the buyer has to make
up the difference outside this business, or the seller must become flexibletoward providing $330,000 of seller financing, or find another buyer withmore cash, or the estimated price must be ‘‘squeezed’’ to fit the conditions
of the projected buyer Stated at the outset, our seller agreed to providesome financing, as long as he could realize at least $250,000 prior topersonal taxes The $890,000 forecast through down payment and insti-tutional financing more than meets the target, thus we can proceed toinsert seller debt into the equation
Annual Principal/Interest Payment 48,046
Total Annual Principal/Interest Payment $ 116,370
Trang 14The Valuation Exercise 153
Testing Estimated Business Value
Return: Net Cash Stream to Be Valued $ 171,935
Less: Annual Bank Debt Service (P&I) ⳮ 116,370
Less: Est Dep & Amortization (Let’s Assume) ⳮ 33,930
Less: Estimated Income Taxes (Let’s Assume) –0–*
Net Operating Income (NOI) $ 47,969
*Debt service includes an average $26,334 annual principal payment that is traditionally recorded
on the balance sheet as a reduction in debt owned This feature recognizes that the ‘‘owned equity’’ in the business increases by this average amount each year Tax obligations are reduced since increased interest expense is deductible from business cash flow.
Return on Equity:
Pretax Equity Income $ 81,899
Return on Total Investment:
Net Operating Income $ 47,969
Total Investment $1,220,000
Note that returns change quite a bit under our new scenario, but thereturn on equity is still high in relationship to alternative investments forthe $300,000 cash being used as down payment
Buyer’s Potential Cash Benefit
Pretax Cash Flow (contingency not considered) 55,565
Discretionary and Nondiscretionary Cash $160,829
*Assumes that buyer would increase salary to avoid double taxation by paying taxes at the business level.
As a matter of practicality, I know that the owner of this business drew take-home pay slightly over $160,000 in pretax 1992 dollars Theactual earnings of a present owner has always been somewhat of a bench-mark criterion that I shoot for in terms of evaluating a prospective buyer’spotential earnings Some people remark that this is giving away the
with-‘‘kitchen sink,’’ but I don’t think so, particularly when you consider that
Trang 15owners can stay in their businesses and continue to earn if they wish to
do so I have another philosophy to share: Buyers are not obligated tofeather the nest of sellers ever! There’s a happy median for both, and
that’s usually the point at which sellers and buyers are equally stretched
by the process of actual sale To my way of thinking, that is where truebusiness value lies Prospective buyers should not, in the process of pur-chase, be able to immediately earn more than sellers have earned, but atthe same time, sellers cannot expect to earn from their buyers what theycould not earn from their business while they ran it The debt leverage ofcash streams can be tight as a drum in the purchase of fast-growing com-panies, but in cases like this retail operation, where sales, earnings, and
growth are stagnant, the prospective buyer deserves wiggle room to expand
the business in years to come That means that more ‘‘jingle’’ must bedumped into the buyer’s equation or the business simply won’t sell If theestimated value does not forecast a likely sale, then the estimate is wrong period!
Seller’s Potential Cash Benefit in Sale
*From which must be deducted capital gains and other taxes Structured appropriately, the deal qualifies as an ‘‘installment’’ sale with the proceeds in seller financing put off regarding taxes until later periods.
Projected Cash to Seller by End of 10th Year
Add: Projected 10-Year Principal and Interest Payments to Seller 480,457
This owner paid $600,000 for his business seven years ago That’s128.4% return on his original purchase, or an average dollar return of
$110,065 per each of the seven years between 1986 and now This doesnot include what he earned in the way of salary for operating his business
$290,000 over his original purchase ($890,000 in cash minus $600,000)might be likely realized on a date of sale Calculated any way one wishes,return to this owner is just and wouldn’t be likely to be repeated in thestock market or in a job with corporate America Want to know the end
of the story? I’m happy—this was my business I was the seller! I sold
the business separate of real estate, ultimately sold the real estate later to
an investment group, sold the wholesale carpet division separately, and Igrew richer in the process The years were 1969, 1970, and 1971—not