A Basic Guide for valuing a company phần 8 pdf

Total Current Assets Total Current Liabilities 2001 Industry Median Less than a ratio of 1.0 can suggest a struggle to stay current withobligations.. quar-Sales Total Working Capital 200

Reconstructed Expenses $ 201,463

Ratio Study

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

2001

Industry Median

Less than a ratio of 1.0 can suggest a struggle to stay current withobligations The median offers that the industry as a whole may wrestlesomewhat with liquidity problems by the nature of doing business; how-ever, the top 25% of reported companies reflect a ratio of 1.5 Thus we

The Valuation Exercise 201

might conclude that this grocery store starts out close to the upper tile from an industry perspective

quar-Sales

Total Working Capital

2001

Industry Median

1 Current assets minus 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 Our casestarts out slightly above the industry median

At this point, we can add three more for comparison

Earnings Before Int./Taxes

Annual Interest Expense

2001

Industry Median

This ratio measures a business’s ability to meet interest payments Alow ratio indicates that a borrower may have difficulty in meeting interestobligations

Total Liabilities

Tangible Net Worth (Equity)

2001

Industry Median

High ratios indicate high risk being assumed by creditors (in this case,the seller) A low ratio suggests that a business has more flexibility in futureborrowing

Now for the fun of it, let’s try a discounted method to see what wecome up with Bear in mind that there is no evidence for growth In fact,there should even be a question about using the 3.5% cost of living ad-justment that we will use

Discounted Cash Flow of Future Earnings (The theory is that the value

of a business depends on the future benefits [earnings] it will provide toowners Traditionally, earnings are forecast from a historical performancebase into some number of future years [usually 5 to 10 years] and thendiscounted back to the present using present value tables.)

In our grocery business both sales and earnings may well have peaked.This leaves us with the prospect that ‘‘present’’ dollars will lose ground

as we move into future years Let’s use just four years For the sake ofargument, we’ll use the completed 2001 year as suggested in the buyer’sratio study above and use increases at no more than cost of living differ-entials of 3.5%

Establishing Expected Rate of Return (The rate expected as a return

on invested capital) For the loss of liquidity and venture rate of returns inthe range up to 25%, let’s assume 20% as a level of return on risk associatedwith small-business ownership We’ll also assume the earnings plateau inthe fifth year at $85,000

Value of Grocery Business

$75,101

(1 Ⳮ 20)

$77,730 Forecast Year 2 2 ⳱ $ 53,979*

(1 Ⳮ 20)

$80,451 Forecast Year 3 3 ⳱ $ 46,557*

(1 Ⳮ 20)

$83,267 Forecast Year 4 4 ⳱ $ 40,156*

(1 Ⳮ 20)

($85,000 divided by 20)

(1 Ⳮ 20)

*Future earnings discounted to present value.

Summary 203

On the basis of the discounting method, we might choose to negotiatethe purchase of our grocery store business for a price of $408,234 or less

Summary

In this chapter I have attempted to provide a range of formulas applied

to a business that enjoys quite a residual value but may not portend anysubstantial future growth There are many small businesses in Americasuch as this one They may not provide investments for the adventure-some, but they do afford ‘‘catch basins’’ to many caught up in the down-sizing likely to continue This grocery business appears relatively safe frominvasion by the ‘‘bigs’’ due to its particular location However, growth, if

any comes, will be through the innovation and expense of its new owner.

I’ve included the discounted method not for any real practical use butmostly to show what can happen to investments made now without anyreal assurances for future growth We all have been experiencing an ero-sion of our dollars in recent years Although this business provides a goodjob for someone without great alternatives, the price paid for that job interms of today’s dollars could become quite high longer term Casualobservance of the bottom lines of the income statements by the unwaryleads one to garner a sense of growth However, the flatness of sales forthree years, plus slim forecasts, should dispel any such sense and mightwell be painting the picture of a typical business that one should notoverpay for in terms of price and terms at purchase With dust settling onthe information provided in this chapter, one can wonder if retirementwas the sole reason this owner wished to sell

‘‘The art of life is to know how to enjoy a little and to endure much.’’

William Hazlitt

com-to be either the employment of direct sales forces or the use of dent manufacturing representatives, or a combination of both In the firstsituation, ‘‘compensation’’ shows up on income statements as either directsalary or through blends of both salary and commissions The secondcondition reflects commission only as a general rule.

indepen-On the other hand, mail-order distribution presents unique expensecharacteristics that make forecasting inordinately difficult To understandwhy, we must specifically address features of this form of selling Perhaps

we pay little attention to this process when we, and we all do, receivecatalogs from a wide variety of mail-order houses Do you have any ideawhat these catalog production and mailing expenses might be per distri-bution? The expense for full-color catalogs from L L Bean and SharperImage, for example, would make you shudder and question how thesesorts of companies can make any money at all Granted, when catalogsare produced in very large quantities, the price per issue is held down Butwhat about the cost of small-run production for the ‘‘little’’ guy? Most of

us are aware of the ‘‘price-break points’’ we obtain when we need simplerprinting jobs done In the production of catalogs we must add the expense

of folding and binding that might also enjoy quantity discounts

Through another dimension, we must deal with shipping and postageexpense Both of these costs can be enhanced or exacerbated by factors

of ‘‘weight.’’ Thus, the cost of design, layout, and printing must be

con-Manufacturer with Mail-Order Sales 205

sidered fully in light of ‘‘delivery’’ expense, and these costs balanced inrelationship to projected consumer purchases

That’s not all, folks, because there is the very real (but quite hidden)cost when a catalog mailed does not produce greater than breakeven sales.According to national direct-mail marketing statistics, mail-order housescan count on little more than 2% to 5% returns from the total mailing listused Some, such as the example in Chapter 14, ‘‘Seventy Cents on theDollar,’’ do a little better To increase the odds of greater returns, thesehouses ‘‘clean’’ their customer lists frequently and spend considerablesums focused on catalog design and content Many have policies of drop-ping potential customers when a ‘‘name’’ does not buy at least once ortwice per year It is costly to manage these customer lists Smaller housesmay engage ‘‘list-management’’ businesses to perform these cleaningtasks Expense for list management is quite regularly subsidized through

‘‘renting’’ the lists to other mail-order businesses, regularly including the names of customers who have not made purchases At the consumer end,

this translates into a mounting plethora of unsolicited junk mail times list rentals will entirely subsidize management fees, and sometimesnot The value of any list to its owner depends on the ‘‘quality’’ or number

Some-of frequent buyers The value to a renter depends a great deal on thedegree of ‘‘comparable’’ buyers in a list Since each list owner attempts towhittle and model (make unique) a mailing list to his or her specific prod-ucts and/or services, the process of others gleaning productive names forthemselves from this list can be hit or miss It is also costly in terms of the

‘‘experimentation’’ necessary to reduce the purchased list to the few morenames added to the renter’s base

The variableness in catalog production and customer delivery makessales and expense forecasting for mail-order businesses quite difficult, tosay the least One other irregularity must be highlighted as well Shipping

of actual products to the consumer can add to operating expense though most catalog distributors pass this freight expense along to theconsumer on the basis of ‘‘average’’ weight/cost, without conductingfrequent audit, these costs can get out of hand as well

Al-Forecasting in mail-order businesses, and subsequent management,presents a need to fully understand all of its stratified complexities of mar-keting As was noted in Chapter 14, the mailing list itself requires sub-stantial attention to hold down the cost of producing sales and to

‘‘massage’’ a company into greater revenues As noted in our turing example, the manufacturing process alone requires special treat-ments to stay in control of the game When manufacturing and mail-orderdistribution are combined, we find the essence of very complex businesses

manufac-I’m not saying that they can’t be profitable, because many succeed; ever, they tend to be inordinately labor-intense due to their many facets

how-in production and markethow-ing In this age of technology, I can’t thhow-ink of

a better example where computer numerical controllers (CNCs) andcomputer-assisted management can be more directly and cost effectivelyapplied in a small business

Brief Case History

Our assignment is to provide an estimate of value for the business’s dictable’’ sale The owner describes his business and personal financialconditions as not as good as he would like

‘‘pre-The company is housed in a large factory building containing first-floorproduction space and a sail-making loft In addition to high-quality main-sails, headsails, and spinnakers, the company manufactures six items ofboat hardware and two lines of winches The business has been in opera-tion for nearly 60 years and has had three owners in the past 8 Productsare offered to the public through direct mail; however, the company ded-icates a small front section to a retail factory outlet that is opened for twomonths in the spring of each year The company enjoys an excellent after-market reputation for its products

This company is, once again, my client; thus, for a number of reasons,

I have elected to restate financial information, using a computer routinethat downsizes its much larger operation Data, however, are presented inthe actual relationship as they appear in the company’s statements Sub-sequently, conclusions also reflect these smaller proportions and modelresults found in the larger company

Boat Products Mail-Order Manufacturer

Brief Case History 207

Total Property and Equip $151,833 $129,546 $101,892 Other

TOTAL LIABILITIES & EQUITY $810,197 $828,738 $652,589

Boat Products Mail-Order Manufacturer Reconstructed Income Statements for Valuation

I also caution you to observe accompanying balance sheet ‘‘confusion.’’Stockholder equity has decreased during this same period from $124,997

to $54,387 I don’t know about you, but I suspect a ‘‘fly in the ointment’’someplace It’s called pressure on the owner’s pocketbook! 1992 cash is

negative, receivables have decreased in one year by $54,315, and payables

by $34,020 for that period Although cash flow seems nicely increased,I’m quite naturally suspicious about whether ‘‘customer deposits’’ of

$43,718 are reserved in liquid form at this point I am also cognizant that

‘‘notes’’ under liabilities have increased by $11,523 between 1991 and

1992 An earlier concern that 1992 income and expenses might have beenstretched or shrunk in preparation for business sale was alleviated throughexamination of the checkbook and other business records I’m confidentthat the financially astute will find other concerning issues in these state-ments However, for the purposes of our mission—the process of valu-ation—this allusion to financial analysis will suffice

Financial Analysis 209

Ratio Study

I do not believe that this small company is uniquely alone in its cation, but I am unable to find an ‘‘industry resource’’ for comparison toboth boat product manufacturer and mail-order selling Another issue thatcomplicates analysis further, and as happens in many small businesses, isthat this company commingled its operations and financial record keepingsuch that it is impossible to sort various criteria into ‘‘pots’’ for appropriatecomparison This does not, however, mean that ratio study will not helpbetter understand year-to-year performances

of supply for material and findings in sail manufacture Though it is stilltoo early to tell, no apparent sacrifice in quality is evidenced at the con-sumer level thus far

(Income Statement) Sales

This highlights the average time in days that receivables are ing Generally, the longer that receivables are outstanding, the greater thechance that they may not be collectible Taken alone, this dramatic re-duction in collection time seems positive, but it’s the dramatic reductionover a relatively short period that should cause some alarm Few consum-ers take kindly to being ‘‘muscled’’ and in an era of 30-day credit terms,the shrinking to 10 days might suggest undue pressure—and, ultimately,the potential for reduced sales.

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 improving in this department, which might be

a surprise to some readers Although only a subtle indicator, this might

be a signal that while the owner is struggling, he appears to be doing some

of the right management things with the cash obtained

To analyze how well inventory is being managed, the cost of sales toinventory ratio can identify important potential shortsightedness

Financial Analysis 211

better skills at marketing, whereas a lower turnover of inventory may dicate shortages of merchandise for sale, overstocking, or obsolescence.This company maintains what seems to be near-oppressive levels of inven-tory As noted in the following, inventory builds up to a high level andthen is largely depleted during a two- to four-month spring and summerperiod While this may be a necessary characteristic for boating products

in-in the northeast, it seems that there may be a management opportunityhere for improvement

Conclusions

To fully understand the benefit of examining ratios without industry parisons, one must call on accumulated practical experience Therefore,competent financial professionals should be consulted for that advice

com-However, in the front of the Annual Statements Studies conducted by

Robert Morris Associates, one can find a brief but easy to understandmeaning of the various ratios and their interpretations One does not need

to be a financial genius to recognize some of the problems being enced by this company Cash is obviously short and there may be unduepressure being exerted upon customers to pay their bills (obviously, toomuch might hurt future sales), but there is some indication that presentmanagement is directing available resources in an appropriate manner Thebalance sheet seems inordinately burdened in light of present-day sales.The income statements, particularly 1992, seem inconsistent with thestruggle indicated on the balance sheets As a professional observer, myfirst inclination was to be quite suspicious that this owner had ‘‘tam-pered,’’ by overstating sales, or understating expenses, in his IRS Form

experi-1120 return No formal audits had been conducted Closer examination

of business records indicated several peculiarities to this specific business.Huge lags are experienced between manufacturing and mail-order con-sumer delivery, thus inventories are being maintained at unusually highlevels Since most sales (boating products) are realized in the northernclimate, revenues surge in the spring of the year Those of us living inthese areas can be most appreciative of consumer patterns in the north

We tend not to think about summer activities until the spring thaw and then we expect ‘‘instant gratifications’’ to fill our soon-to-come ac-tivity needs This company can predict permanent cancellations on anyorder that they cannot immediately fill Subsequently, manufacturing ofproducts (and inventory) builds up to a crescendo of sales in the spring

of the year Attempts at winter sale through catalog mailings have beencostly and have generally failed to produce breakeven results The balance

sheet item for ‘‘Boats’’ includes the complete show regalia for a moment’snotice exhibition (the owner admits that he does not plan well in advancefor these shows) Show expenses contain losses in each of the three years

on the sales (rather than pay transportation back to home base) of a and 16-foot sailing dinghy used for these exhibitions By the end of 1991,this company had implemented a piecework pay system on all productionlines but winches While all ‘‘bugs’’ are not ironed out, the owner feelsthat the 25% to 28% reduction in wages has not deterred quality in prod-ucts Sail makers seem content with the new pay system; however, theowner is concerned about increasing entry-level employee turnover inother lines The system designer has returned to examine what might bedone to reduce this problem Apparently it takes about three months toreach earnings-level proficiency from the day of employment A combi-nation base-pay/piecework-rate arrangement is currently being discussed

14-to accommodate new entrants

The owner summarizes the major problem in his company as the tions being too seasonal He has not explored the prospects for partialplant shutdowns or staggered production schedulings; nor has he calcu-lated the alternatives in other forms of marketing He admits that some-thing must be done differently to survive long term, but he feels that toomuch of his time is taken up in brushfire management as opposed toexamining various alternatives that might increase profits A whole drawer

opera-in a file cabopera-inet opera-in his office is dedicated to the plethora of complimentaryletters from satisfied customers Several long-term employees have ex-pressed interest in owning part of the company, but this owner is con-cerned that this may not be the answer He claims his own strengths arehighest in managing production, which is also the strength of these po-tential partners His assessment suggests that needs lie in the areas ofgeneral and marketing management, thus he would entertain selling part

of the company to someone possessing these attributes or sell outcompletely In the event that such a partner could be located, he feels that

a significant cash infusion will be necessary to fund expected changes tooperations He is not opposed to some owner financing under this con-dition As a backup scenario, he would consider selling to employees—but only for all cash at closing

Before proceeding with the valuation task, however, we must ascertainwhat assets and liabilities will be offered for sale with the business In-cluding or excluding assets and liabilities should not be arbitrary andshould minimally include what is necessary to reproduce past year’s sales.What is excluded by sellers can become ‘‘added’’ start-up expense forbuyers

In taking this step of reconstructing balance sheets to reflect whatowners wish to sell, it is important to recognize that ‘‘book value’’ and

‘‘adjusted book value’’ do not represent those sellers’ true financial ditions Instead, we are applying formulas, and extracting results, thatcan be misleading in terms of the ‘‘real’’ business value and, more im-portant, misleading in how the reconstructed balance sheet might affect

con-re-creating the historical picture of sales and expenses concurrently being

presented to potential buyers For example, the act of removing ‘‘cash’’through reconstruction translates into the need for added working cap-ital by a buyer In our case, accounts payable exceed accounts receivable

by $42,454 and predict an additional depletion of working capital sources as the business continues to function Though overall asset valuesmight increase in worth through reconstruction, ‘‘liquidity’’ can becomeseverely strained in a process that fails to include working capital require-ments It is not uncommon for sellers of small companies to retain cashand other more liquid business assets at closing And it is a commonfailure of buyers to put the required due diligence into assessing theirneeds for working capital after the closing

re-I feel that this minor derailment from our task of valuation was essary at this particular point Many formulas tend to ignore this missingand vital link between needed working capital and a business’s value

nec-The Valuation Exercise

Book Value Method (items for sale only)

Total Assets at Year-End December 1992 $643,657

Book Value at Year-End December 1992 $524,248

Adjusted Book Value Method (items for sale only)

Adjusted Book Value at 12/92

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

Yield on Risk-Free Investments Such as

Risk Premium on Nonmanagerial Investments a