As previously posted, there are 4 key issues that must be considered when performing valuations on business entities. Ignoring them (or confusing them) can make a valuation analysis less reliable, or, in the worst case, just downright wrong.
The first issue we discussed was the basis of value. Here, we’ll discuss the second issue to consider – selecting relevant financial components. If you’ve seen as many financial statements as we have, you’d understand why this issue is so important.
When assessing the financial health of a company, we first try to compare the current period financial statements to those from at least the previous three-to-five years (or more depending on the type of analysis and relevance of earlier periods). For a meaningful comparison, it is important to know the basis of each financial statement being assessed. Specifically, it is important to know if the statements are based on tax return information, are accrual based, are cash based, or are a combination (hybrid). Sometimes, due to limitations of timing or resources, periods with different bases are used. Knowing the differences between the two types of basis will help clarify any discrepancies when comparing the underlying numbers.
Additionally, for financial damage or lost profit analyses, it may be beneficial to determine whether expenses are of a fixed nature (i.e., expenses that do not change with changes in sales activity; for example rent expense), variable nature (i.e., expenses that change with changes in sales activity), or exhibit characteristics of both fixed and variable nature. Understanding the role of each expense line item in the manufacturing/operational process can help in identifying how to classify each expense line item. Going through each item with company management who are familiar with the expenses and their nature is an important step.
Lastly, classifying all components of the financials (including both income statement and balance sheet) into operating (e.g., working capital, operating assets and liabilities) and non-operating (which can often be personal in nature; e.g., extraneous company cars, real estate investment property, etc.) can help differentiate between the components that impact the ongoing, operating cash flows (these will be used to value the business!) and those that do not directly impact the operating cash flows. In one case, a privately-held service company had three company airplanes on its books. We determined the use of the airplanes had a quasi-business related nature (i.e., at least a portion of the use of the planes had reasonable business uses). However, when assessing whether a hypothetical buyer (as warranted in our tax-related valuation) would need the three airplanes to achieve the expected financial results reflected in the projections, we determined that at most, only one airplane was necessary. Therefore, the other two airplanes were considered as having a non-operating (i.e., personal) nature. Accordingly, their fair market value was added to the value of the operating company (as non-operating assets) and the expenses related to those two airplanes were removed from the operating expenses. The effect of removing those expenses from the operating expenses increased net income related to the operating business.
Selecting relevant financial components requires consistent bases for comparison, determining the fixed or variable nature of expenses (if needed), and classifying all components as operating or non-operating. Our valuation specialists are very experienced in selecting relevant financial components, which is an essential element of obtaining a reliable and appropriate valuation. In future posts, we’ll explore the remaining two key issues that are essential to performing reliable and appropriate valuations. In the meantime, if you have any questions about how to select the relevant financial components for your valuation assignment, please contact either Dan Branch at 770-635-1582 or Marty Varon 770-635-1569. How can we help?
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