Brief Case History 173 Retail Garden CenterReconstructed Income Statements Balance Sheet Reconstructed to Show Fair Market Value of Assets Being Offered for Sale... The Valuation Exercis
Trang 117 Retail Garden Center
Garden centers may or may not also be ‘‘growers’’ for both retail andwholesale distribution Some produce their own vegetable and flowerseeds and seedlings and engage in mail-order distribution Others providelandscape horticultural services and engage in landscape planning, archi-tectural, and counseling services, as well as offer a variety of ornamentalshrub and tree pathology services Many offer garden tools and, depend-ing on location, may also sell and provide repair services for larger gas-and electric-powered tractors and implements However, smaller centerstend mostly to sell products purchased from others; some may also sellplants and shrubs that they grow themselves Services specifically offered
at individual garden centers depend largely on the size of operations and/
some-a csome-ash stresome-am is unique to some-a specific owner, then thsome-at psome-art must be removed
or ‘‘subdued’’ in the equation of fair market value On the other hand, if
a prospective buyer is ‘‘defined’’ or limited to persons with similar skills,then this portion may be included Bear in mind, however, that when onesubstantially narrows the field to unique prospective buyers, then one alsotends to compress price or value It’s all in the economics of supply anddemand and supply and demand are always major ingredients in es-timating business value
Trang 2Brief Case History 171
Brief Case History
Our retail garden center is situated on a major road between two sized small communities Although the center offers a wide range of or-namental shrubs, flowers, and seeds, it specializes in growing and culturingsmall bonsai trees In addition, the company has specialty plantings thatshould reach harvest size in two years Traditional nursery stock and sup-plies are offered from a 6,600-square-foot building situated on a three-acre site An independent landscaper works from the premises No rent
similar-or utilities are bsimilar-orne by the tenant insofar as all plants, shrubs, and suppliesare purchased from the garden center One section of the store containsarts and crafts supplies, as well as holiday decorating products The centerhas been under the same husband/wife ownership for nine years Due tothe owners’ age and physical health, the purpose for valuation is businesssale
Up to this point I have not covered my secondary reasons for includingratio analysis in business valuation assignments You’ve heard me talk oftenabout supply and demand issues Short supply, when there is high demand,raises prices and vice versa It has been long said that good small companiesare hard to find and buy Those in the market for small businesses canguess, if they don’t already know, that there are far too many buyers chas-ing too few good deals In my companion book on buying and sellingsmall companies, I show estimates that only one out of five businesses on
the market actually sell Ratio analysis can tip us off to the positioning
enjoyed by target assignments If, for example, the target fits into the top25% of comparable firms, then we might secure greater yield from actualsale On the other hand, exacerbating conditions may compress the tar-get’s yield from sale As value processors, we can never afford to lose sight
of those conditions predicting marketability Since cash rules quite often
in business sales, high cash flows being thrown off can serve to offset someundesirable aspects of a business’s marketability Thus, strong ratio evi-dence can enhance the selling scene and value estimate On the otherhand, weak ratios can tip the value processor into a mood of cautiousestimating
Trang 3Retail Garden Center Balance Sheets
Trang 4Brief Case History 173 Retail Garden Center
Reconstructed Income Statements
Balance Sheet Reconstructed to Show Fair Market Value
of Assets Being Offered for Sale
Trang 5Financial Analysis
One key point on this business’s nonreconstructed balance sheet might
bother the average value processor a bit: the disproportionate amount ofpayables to receivables Classic accounting texts tell us that a ratio of one
to one is reasonably healthy, and of course, higher receivables than ables suggest greater liquidity Let’s think about the nature of the gardencenter business for a moment Retail purchasers, since these products arenot ‘‘basic necessities,’’ will tend to pay in cash or charge to a credit cardwhat they buy Bad debt tends to be low, because retail purchasers whomay be at risk tend not to extend themselves buying these products Re-ceivables are most often limited to landscape contractors, and these con-tractors, more often than not, will seek wholesale distributors rather thanretail garden centers as sources of supply Subsequently, low receivables inrelationship to payables are not uncommon for businesses such as this.Growth of equity in our target business has been limited to principalpaydown on mortgages and notes These owners elected to ‘‘zero’’ theirbottom lines each year through salaries paid to owners; thus, no retainedearnings and no increase of equity provided by business cash flows.While I personally prefer to allow small amounts of ‘‘trickle-down’’ earn-ings, if for no other reasons than for possible refinancing or for securingworking capital loans, these owners felt no need to worry about bankexpectations
This ratio measures the percentage of sales dollars left after cost ofgoods sold is deducted Higher than the industry median, this gardencenter enjoys a good yield due to the bonsai segment The owners employtwo ‘‘specialists’’ who grow and cultivate these small trees These skillscan be learned by a new owner, if so choosing, and local market conditionsindicate reasonable ease of finding employee replacements if required
Trang 6Financial Analysis 175
Once again it should be noted that ratios for net profit, before and aftertaxes, can be most useful ratios But the fact that private owners frequentlymanage their businesses to ‘‘minimize’’ bottom lines will often producelittle meaningful information from these ratios applied to smaller busi-nesses Therefore, these ratios are not included
The current ratio provides a rough indication of a company’s ability toservice its obligations due within the time frame of one year Progressivelyhigher ratios signify increasing ability to service short-term obligations.Bear in mind that liquidity in a specific business is critically an element ofasset composition Thus, the acid test ratio that follows is perhaps a betterindicator of liquidity overall
Total Current Assets
Total Current Liabilities
Industry Median
A ratio less than 1.0 can suggest a struggle to stay current with gations The median suggests that the industry as a whole may wrestlewith liquidity problems, and the top 25% of reported companies reflect aratio of only 9 Thus we might conclude that this garden center hasmoved close to the upper quartile from an industry perspective
Trang 7obli-(Income Statement) Sales
Receivables (Balance Sheet)
Industry Median
This is an important ratio and measures the number of times that ceivables turn over during the year It symbolically represents my preced-ing comments wherein garden centers tend largely to generate cash sales.Although our target company seems to have slipped a bit in 2001, thiscould be no more than a quirk, since other years have been relativelystable However, it points to questioning why receivables more than dou-bled in 2001
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, four years show regularity in collections, and a sharp peak occurs
in 2001 Much of the problem rests in two larger ‘‘jobs’’ where there wasjoint agreement for 90-day terms
Generally, the higher the turnover rate, the shorter the time betweenpurchase and payment Lower turnover, which our target company ex-periences, indicates that it may frequently pay bills from daily in-store cashreceipts due to slower receivable collections This practice may be some-what misguided in light of investment principles, whereby one normallyattempts to match collections relatively close to payments so that more
Trang 8Financial Analysis 177
business income can be directed into the pockets of owners Some nesses may, however, have little choice Our company owner admits tobeing lax at pursuing collections but claims never to have suffered baddebt as a result
Note: Current assets minus 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
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.Our case example, while improving, falls into the lower quadrant andsuggests inventory may be quite heavily overstocked or contain largeamounts of distressed or unsalable merchandise
Conclusions
This case presents a fairly stable operation with one possible exceptioncaused by what appears to be excessive inventory Close examination ofinventory revealed two important facts Six years ago, two acres wereplanted with seedling ornamental shrubs of their highest turnover cate-gory These are harvestable in two years, and a rotational grow/sell planhas been developed The present owner believes that this move curtailsincreasing problems with supply and will increase gross profits if the prac-tice is continued Inventory, therefore, has been accepted at current levelsfor the purpose of business valuation
Trang 9The Valuation Exercise
Book Value Method
Adjusted Book Value Method
Assets
Balance Sheet Cost
Fair Market Value
*See reconstructed balance sheet.
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 179
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%
busi-Weighted Cash Streams
Prior to completing this and the excess earnings method, we must oncile how we are going to treat earnings so that we have a ‘‘single’’stream of cash to use for reconstructed net income I prefer the followingtechnique:
rec-(a)
Assigned Weight
Weighted Product
Trang 11sales jumping up by 19.1% in 2001 The free cash stream grew by 41.1%that year Mathematicians may not agree with my following simple logic,but it works for me every time If nothing more, it gives tangible recog-nition for unusually good performance, all of which is verified in previousyears However, valuators should always assure themselves that there isreasonable likelihood for future repeat performances and that an excep-tional year is not a quirk occurrence.
What we now need to decide is the ‘‘power’’ of the sales/income factor
in the weighted cash stream Again, not from the books of cians, but working well: Sales grew by 19.1%, and income by 41.1%, thus,divide 41.1% by 19.1% and we get 2.2%—rounded, a factor of (2) Wecan now complete our weighting process
mathemati-(a)
Assigned Weight
Weighted Product
Trang 12The Valuation Exercise 181
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 $ 93,960
Cost of Money
Market Value of Tangible Assets
(what’s being offered for sale) $528,390
Excess of Cost of Earnings
Return Net Cash Stream to Be Valued $ 93,960
Intangible Business Value
Times: Intangible Net Multiplier Assigned ⳯5.0*
TOTAL BUSINESS VALUE (Prior to Proof) $733,995
(Say $735,000) Financing Rationale
Less: Down Payment (approximately 25%) ⳮ 185,000
*See Figure 9.1 in Chapter 9 for net muliplier.
Once again we must draw assumptions (best to specifically check outwith local bankers) prior to completing our assessments The followingrepresents preliminary quotes from a commercial bank in the locale of ourtarget company
Land & Building ($320,000) at 70% of Appraised Value $224,000 Equipment ($23,770) at 70% of Appraised Value $ 16,639
(Say $325,000)
*Inventory contains approximately $40,000 of shrubs and plants in the ‘‘growing’’ stage that are possibly not harvestable for about two years This business is located in a northern zone where seasonally unsold plants and shrubs must be planted or maintained through winter months Subsequently, winter kill could be high as viewed by the bank.
Trang 13Bank (10% ⳯ 15 years)
Testing Estimated Business Value
Less: Est Dep & Amortization (Let’s Assume) ⳮ 18,313
*Debt service includes an average $6,100 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 (ROE):
Pretax Equity Income $ 62,425
⳱ ⳱ 33.7%
Down Payment $185,000
Return on Total Investment (ROI):
Net Operating Income $ 33,974
⳱ ⳱ 4.6%
Total Investment $735,000
Although 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 As mentioned so often along theway, I do not believe that small-company buyers pay all that much heed
to ROI it’s King Cash that leads the way
Buyer’s Potential Cash Flow Benefit
On the one hand, we have estimated business value; on the other hand,
we may not have hit our target estimation A $185,000 cash down
Trang 14pay-The Valuation Exercise 183
ment plus $325,000 bank financing, or $510,000, leaves us with a
$225,000 shortfall yet to be financed If we leave the price at $735,000,either the buyer has to make up the difference outside this business or theseller must become flexible toward providing $225,000 of seller financing,
or find another buyer with more cash, or the estimated price must be
‘‘squeezed’’ to fit the conditions of this buyer How then might we resolvethe discrepancy?
1. We know that we are $225,000 short of financing
2. We know that we have an income stream of $97,288 ($103,388minus noncash equity buildup $6,100) A decent stream in light ofcash outlay at purchase
3. We know that most sellers are anxious to receive cash as quickly aspossible
4. Assuming that a salary of $45,000 is typical to equivalent work ing done by other managers in this field, then we can also assumethat we have wiggle room to retrofit additional financing into theequation (but we must still leave room for down payment invest-ment returns of some sort)
be-In attempting to solve for this question, we return to the point in theequation for Financing Rationale
Total Annual Principal/Interest Payment $ 92,382
Testing Estimated Business Value
Return: Net Cash Stream to Be Valued $ 93,960
Less: Annual Bank Debt Service (P&I) ⳮ 92,382
Less: Est Dep & Amortization (Let’s Assume) ⳮ 18,313
Less: Estimated Income Taxes (Let’s Assume) –0–
Net Operating Income/Loss (NOI) $ –6,704
Trang 15A bit ‘‘tight’’ you say? You’re right it is too tight to sell to a buyer
of this garden center Bear in mind that we did just this in a previousexample, but that case had much higher cash flow and personal earnings
to a potential buyer I use a rule-of-thumb earnings (as full cash proceeds)
to a buyer predicting a return of down payment in about three years Thus,
in this example, $185,000 divided by three equals approximately $62,000between estimated salary and business returns This will not always be thecase, of course, but it is a reasonable expectation So, let’s try the ‘‘fi-nancing’’ and ‘‘testing’’ portions again
Annual Principal/Interest Payment 32,758
Total Annual Principal/Interest Payment $ 70,394
Testing Estimated Business Value
Return: Net Cash Stream to Be Valued $ 93,960
Less: Annual Bank Debt Service (P&I) ⳮ 70,394
Less: Est Dep & Amortization (Let’s Assume) ⳮ 18,313
Less: Estimated Income Taxes (Let’s Assume) ⳮ 1,875*
*Debt service includes an average $21,063 annual principal payment (increases from $10,031 with addition of seller financing) 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 Tax obligations are reduced since interest expense is deductible from business cash flow.
Return on Equity:
Pretax Equity Income $ 44,630
⳱ ⳱ 24.1%
Down Payment $185,000
Return on Total Investment:
Net Operating Income $ 24,441
⳱ ⳱ 3.3%
Total Investment $735,000