In 2002 total receipts for all U.S. firms was 22.8 trillion dollars. Of that amount only 770 billion dollars was generated by non-employer firms. Employer firms made up about 24% of all firms and accounted for over 96% of all receipts.
According to the U.S. Census Bureau in 2004 there were a total of 25,409,525 businesses. Of that number 5,885,784 were classified as employer firms ( having a payroll ). Firms with 100 or more employees numbered only 123,983. In U/W we are dealing mostly with firms with < 100 employees.
In 2004 about three quarters of all U.S. business firms had no payroll. They are called non-employer firms. There were a total of 19,523,741 firms. They only accounted for about 3.4 percent of business receipts, which was over 887 billion dollars. These firms are not included in most business statistics.
Bonds payable Notes payable Total Liabilities Stockholder’s Equity Common stock Retained earnings Total Liabilities and Stockholder’s Equity Total Assets = Total Liabilities + Stockholder’s Equity
Liquidity Ratios Current Ratio = current assets / current liabilities Measure of ability to meet current obligations. A ratio of 2:1 or higher is considered sufficient. A number less than two may be suspect. However, some businesses with a longer inventory turnover or longer receivables turnover may have lower current ratios and be considered stable.
Quick ratio = cash and cash equivalents/current liabilities The quick ratio is an indication of the ability of a company to quickly convert assets to cash to meet obligations in the event of an emergency. A quick ratio of 1:1 is considered adequate.
Debt Utilization Ratios – these ratios measure the extent to which a business uses debt to finance operations. In general the higher the proportion of debt the riskier the capital structure. The use of leverage can enhance return, but too much debt can also increase risk. Organizations with high debt obligations are less capable of weathering financial downtimes. Companies with stable earnings are able to carry higher proportions of debt than those businesses in more cyclical lines of business. Also, companies with high levels of debt may find it harder to obtain additional financing or pay higher rates to get additional financing. This is due to the perceived risk on the part of lenders.
Debt ratio = total debt/ total assets This ratio looks at the relationship between total assets and total debt. The amount of debt used to finance total assets. It is a measure of how efficient an organization has used leverage. A ratio of 1:2 is considered reasonable.
Debt to Equity ratio = total debt/ net worth This ratio looks at the relationship between debt and owner’s equity or stockholder’s equity. It is a measure of the riskiness of a company’s capital structure. The higher the proportion of debt the greater the risk to creditors. Investors would also be at even greater risk in the event of bankruptcy because the creditors claim will be satisfied before investors can recover.
Times Interest Earned operating profit / interest expense This ratio measures the ability of a company to pay interest expense associated with debt from operating profits. The resulting number is how many times over interest can be covered by operating profits. The higher the number the better.
Profitability Ratios There are several different measures that can be derived for profitability and how it relates to sales, return on owner’s equity, return on investment and return on total assets. To be significant these ratios must be compared to industry standards and other companies of similar size and line of business.
Return on Equity ( ROE ) = net earnings / equity This measure is of particular interest to shareholder’s and investors ( owner). This is the rate of return in relation to the equity invested in the business. This answers the question of whether the business is making enough profit to warrant the risk being taken.
Operating Profit Margin = operating profit / net sales A measure of the percentage of each sales dollar that the company keeps as profit. The higher percentage the more effective the company at converting revenues to profit. Particularly useful in comparing companies in similar industries and also for trends within a single company.
Return on Assets ( ROA ) = Net earnings / Total assets This ratio is also known as return on investment ( ROI ). Provides an indication of how profitable a company is relative to total assets. Measures how effective a company is at using assets to generate after tax profits.
Read the notes attached to the statements To get a full understanding of the financial statements the notes should be reviewed. They will contain details about the firm’s accounting policies, any changes in policy and the impact of those changes in the statements. There may also be notes regarding specific accounts such as inventory, investments, long term debt ( term, cost, maturity ) and equity accounts. There may also details about leasing arrangements, income taxes, pending legal actions or any number of other items.
Asset Based Book Value Adjusted Book Value Earnings Based Capitalization of Earnings Discounted Future Earnings
Book Value – This is simply the net worth of the business per the balance sheet. Also can be called owner’s equity or shareholder’s equity. This includes capitalized cost of assets less accumulated depreciation or amortization. Though this method is simple it rarely reflects the market value of a business. For small privately held businesses it is not uncommon for the book value to be zero or a negative number. This can be the result of owners paying large bonuses or excessive salaries to themselves. It can also result from various accounting methods such as LIFO vs. FIFO inventory control or different depreciation methods
Adjusted Book Value – Balance sheet items are restated to reflect the current market value of assets, as best as can be determined. Capitalized assets are usually carried on the balance sheet at historical cost less accumulated depreciation. This can result in values that are not representative of the fair market value. Real estate that is carried at historical cost can be worth well over the statement value. However, it must also be kept in mind that assets themselves do not necessarily bring value to the business. In a valuation situation the assets add value to a business when it can be demonstrated how they can be used to generate revenue for the business.
Adjusted Book Value ( continued ) This method can also be challenging because privately held firms are not required to comply with SEC requirements as are publically traded companies. Privately held companies have great latitude in financial reporting as long as they do not run afoul of IRS regulations.
Mention market approach.
Add to income if salary excessive or deduct from income if salary low Perks – club memberships, leased vehicles or any other expense run through company expenses for benefit of owner. Amortization used to expense intangible assets.
Also added back to income are any owner’s perks that may be found in the expenses of the business. These may include leased vehicles, club memberships or any expense not a normal business expense and for the benefit of the owner. Depreciation and Amortization Interest expense is considered a discretionary expense as owners have varying philosophies on business borrowing. This would not include interest on items considered ongoing and would be present after an acquisition.
There are numerous approaches for determining an appropriate capitalization rate. The perceived risk of the business and the ability to generate reliable earnings going forward are the key determining factors. The higher the risk of the business, the greater the expected return will be from investors or potential buyers of the business. In this situation the capitalization will be higher and the resulting multiple lower. Conversely, in a lower risk business the investor/buyer would not be able to demand a higher rate of return and the capitalization rate would be lower with a resulting higher multiple.
Buyers willing to pay more for less risk in chances for future success.
Many professional firms rely heavily on referrals to attract new clients. The reputation of the practitioner is the key to obtaining referrals. This makes goodwill the primary intangible asset in many professional practices.
Many professional firms rely heavily on referrals to attract new clients. The reputation of the practitioner is the key to obtaining referrals. This makes goodwill the primary intangible asset in many professional practices. Goodwill is defined in the valuation industry as: “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”*
Goodwill can be divided into two forms: Goodwill attributable to the firm – This is goodwill that is generated due to the reputation of the firm name, location or other factors identified by the business rather than individuals within the business. Although difficult to value, it is does increase the worth of the firm. However, it is generally less valuable than professional goodwill. 2) Goodwill attributable to the professional – This is goodwill derived from the skills and reputation of the professional. Since this form is tied to the practitioner it is considered largely non-transferable. However, with cooperation and proper succession planning some professional goodwill can be preserved
Factors Affecting Value 1)Level and stability of practice earnings and/or cash flow 2) Qualifications and work habits of the professionals 3) Age and health of the professionals 4) Specialty and fee schedule including fees earned compared to others in the specialty 5) Trained and assembled work force 6) Reliance on referrals 7) Type of clients and patients served and contractual relationships with third-party payers 8) Geographic location 9) Supply of professionals and competition
Accounts receivable and accounts payable - In a cash-basis business an asset or liability account is often not recorded in the statements. Equipment – in some practices this may only be office furniture, computers and similar items which may be of relative little value. However, in other practices such as dental, medical or optometry there may be significant value. 3) Inventory – This is another asset that may not be recorded in the balance sheet. This can include supplies, inventory for sale or work-in-progress. Work-in-progress can be in the form of unbilled hours or work in progress not yet billed. 4) Various liabilities may be present that will need to be accounted for. These can include property taxes, sales taxes, income taxes, purchases on account, lease payments, earned vacation time by employees to name a few. There may also be contingent liabilities such as lawsuits or product liability claims. 5) Examples of other assets that can be present include pre-paid expenses, leasehold improvements or fully depreciated assets that are still used in the business.
Based on historical prices for businesses sold, it was noted the multiple of owner’s discretionary income ( ODI ) increased with the amount of ODI. ODI < $100,000 – multiple 1.2 – 2.4 ODI $100,000 to $250,000 – multiple 2.0 – 3.2 ODI > $250,000 to $500,000 – multiple 2.5 – 3.6 ODI > $500,000 to $1,000,000 – multiple 2.5 – 4.2 Over $1,000,000 EBITDA was used and multiples ranged 3.5 – 5.5. Over $2,000,000 the range was 5 and up.
Tim Miller, CLU, FALU, FLMI Munich American Reassurance Financial Statement Analysis and Business Valuation
Financial Statement Analysis Liquidity Ratios Current Assets Current Liabilities
Measure of ability to meet current obligations
A ratio of 2:1 or higher is considered sufficient, a number less than 2 is suspect
some businesses with a longer inventory turnover or longer receivables turnover may have lower current ratios and be considered stable
Financial Statement Analysis Liquidity Ratios Cash and Cash Equivalents Current Liabilities
The quick ratio is an indication of the ability of a company to quickly convert assets to cash to meet obligations in the event of an emergency.
A quick ratio of 1:1 is considered adequate.
Financial Statement Analysis Debt Utilization Ratios Debt Utilization Ratios – these ratios measure the extent to which a business uses debt to finance operations. In general the higher the proportion of debt the riskier the capital structure.
Financial Statement Analysis Debt Ratios Total Debt Total Assets
This ratio looks at the relationship between total assets and total debt
The amount of debt used to finance total assets.
A measure of how efficient an organization has used leverage.
A ratio of 1:2 is considered reasonable.
Financial Statement Analysis Debt Ratios Total Debt Net Worth
This ratio looks at the relationship between debt and owner’s equity or stockholder’s
It is a measure of the riskiness of a company’s capital structure.
The higher the proportion of debt the greater the risk to creditors.
Investors would also be at even greater risk in the event of bankruptcy because the creditors claim will be satisfied before investors can recover.
Several models have been developed to classify businesses into groups based on business characteristics with risk levels assigned. The following model was authored by Arthur Stone Dewing ( The Financial Policy of Corporations, 5 th Edition, The Ronald Press, 1953 ) and is a good general guide that can be used for valuation purposes.
Business Valuation Category Capitalization Rate Multiple Old established business with significant hard assets and excellent goodwill 10% 10 Well- established business requiring considerable managerial care 12.5% 8 Strong, well developed businesses susceptible to general economic swings and requiring considerable managerial care 15% 7 Highly competitive businesses with low levels of hard assets requiring average levels of managerial care 20% 5
Business Valuation Category Capitalization Rate Multiple Small, highly competitive businesses requiring little capital investment 25% 4 Large or small businesses requiring special managerial skills of one or more persons with little capital investment and in highly competitive fields where failure is a strong possibility 50% 2 Personal service businesses whose success reflects the skill of the manager 100% 1
A sole proprietor owns a small printing operation. The business is well established with stable earnings and a good competitive position in the market. The company has a net income of $100,000. This company may be considered appropriate for category three and a 15% capitalization rate, or a multiple of 7. An approximate value would be $700,000.
The discount rate used is reflective of the amount of risk for the particular business in question. That is, the amount of uncertainty around realizing the expected future earnings stream. The greater the perceived risk, the higher the discount rate and the lower the valuation for the business.
As with the Capitalization of Earnings Method there are several models that have been developed. One such methodology was authored by James H. Schilt ( “ A Rational Approach to Capitalization Rates for Discounting the Future Income Stream of Closely Held Companies,” The Financial Planner, January 1982 ) and offers five categories with recommended discount rates. These rates are added to a risk-free rate, such as that paid by U.S. Treasuries.
Business Valuation Category Discount Rate #1 – Established businesses, good trade position, good management, stable past earnings, predictable future 6 – 10% #2 – Same as #1 except in more competitive industries 11 – 15% #3 – Companies in highly competitive industries, with little capital investment and no management depth, although with good historical earnings record 16 – 20% #4 – Small businesses that depend on the skill of one or two people, or large companies in highly cyclical industries with very low predictability 21 – 15% #5 – Small personal service businesses with a single owner/manager 26 – 30%
In this example we have a company with projected revenues of $1,146,400 over the next 10 years. Using a discount rate of 10% applied to each of the ten years a total figure of $688,328 is calculated. This is amount represents the value of that revenue stream today to a potential buyer given the assumptions made. A business with a perceived higher risk would be given a higher discount rate and the value calculated would be increasingly smaller as the discount rate increased. For example, a discount rate of 15% would total $556,482.
Business Valuation Valuing Professional Practices
Business Valuation Valuing Professional Practices
Goodwill is defined in the valuation industry as: “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”*
Business Valuation Goodwill Goodwill can be divided into two forms:
Business Valuation Factors Affecting Value *Financial Valuation: Applications and Models, James Hitchner