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Tim Miller, CLU, FALU, FLMI Munich American Reassurance Financial Statement Analysis and Business Valuation
Tim Miller, CLU, FALU, FLMIMunich American Reassurance
Financial Statement Analysis and Business Valuation
Financial Analysis Overview
Perspective on U.S. Business
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.
*U.S. Census Bureau
Perspective on U.S. Business
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.
Perspective on U.S. Business
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.
Financial Statement AnalysisBalance Sheet
Assets
Current Assets:
• Cash and cash equivalents
• Investments
• Accounts receivable net of allowance for doubtful accounts
• Inventories
Long-term Assets
• Equipment
• Land and Building
• less accumulated depreciation
Financial Statement Analysis
Other assets
• Long-term investments
• Goodwill and other intangible assets
Total Assets
Liabilities
Current Liabilities
• Notes payable
• Accounts payable
• Interest ( current portion )
• Taxes payable
Long-term Liabilities
• Long-term debt
Financial Statement Analysis
• 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
Financial Statement Analysis
Income Statement
Sales / Revenues
minus Cost of Sales / Revenues ( a.k.a. COGS ) =
Gross Profit
minus Operating Expenses =
Operating Income
plus/minus non-operating expenses/income =
Total Income
Minus income taxes =
Net income
Financial Statement AnalysisLiquidity 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 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 AnalysisLiquidity Ratios
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.
Financial Statement AnalysisDebt 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 AnalysisDebt Ratios
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. •A measure of how efficient an organization has used leverage.• A ratio of 1:2 is considered reasonable.
Financial Statement AnalysisDebt Ratios
Debt to
Equity Ratio
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.
Financial Statement Analysis
Times Interest
Earned
Operating Profit
Interest Expense
•measures the ability of a company to pay interest expense associated with debt from operating profits•higher the number the better
Financial Statement AnalysisProfitability Ratios
Financial Statement AnalysisReturn on Equity
•Rate of return relative to equity invested in business•Determines if business is making enough profit to warrant business risk
Financial Statement AnalysisOperating Profit Margin
OPM
Operating Profit
Net Sales
•Measure profit per percentage of each sales dollar•Higher percentage more effective converting revenues to profit•Useful comparing
Financial Statement AnalysisReturn on Assets
ROA
Net Earnings
Total Assets
•Also known as Return on Investment (ROI)•Indicates profitability relative to total assets•Measures effectiveness in business use of assets to generate after-tax profits
Financial Statement Analysis
Read the notes attached to the statements:
Business Valuation
Business ValuationBook Value
Business ValuationAdjusted Book Value
Business ValuationAdjusted Book Value
Business ValuationCapitalization of Earnings
A valuation technique under the income approach where a
single representative period is used to determine a value for a
business through application of a capitalization rate. This
expressed as:
Value
Income
Rate
Business Valuation
Determining a reasonable figure for business income is key. Sometimes referred to as Owner’s Discretionary Income.
Business Valuation
Business ValuationCapitalization of Earnings
Capitalization Rate – Business Type / Perceived Risk
RISK
RISK
Business Valuation
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, 5th 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
Business Valuation
Case Sample - Capitalization of Earnings
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.
Business Valuation Discounted Future Earnings
Business Valuation Discounted Future Earnings
RISK
RISKEarnings Unpredictable,Highly Competitive Market,Questionable Competitive Position, Managerial Questions
Business Valuation
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%
Business Valuation
Year Cash Flow Discount Factor 10%
Present Value
1 $100,000 0.9091 $90,910
2 $103,000 0.8264 $85,119
3 $106,090 0.7513 $79,705
4 $109,270 0.6830 $74,631
5 $112,550 0.6209 $69,882
6 $115,930 0.5645 $65,442
7 $119,410 0.5132 $61,281
8 $122,990 0.4665 $57,333
9 $126,680 0.4241 $53,725
10 $130,480 0.3855 $50,300
Total $1,146,400 Total $688,328
Business Valuation
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 ValuationValuing Professional Practices
Business ValuationValuing 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 ValuationGoodwill
Goodwill can be divided into two forms:
Business ValuationFactors Affecting Value
*Financial Valuation: Applications and Models, James Hitchner
Business ValuationCash Basis Accounting
In professional practices cash-basis accounting is often used.
This may make some financial statement adjustments
necessary to value the business.
Historical Perspective on Valuation
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 Multiple
< $100,000 1.2 – 2.4
$100,000 to $250,000 2.0 – 3.2
>$250,000 to $500,000 2.5 – 3.6
>$500,000 to $1,000,000 2.5 – 4.2
Over $1,000,000 EBITDA was used
3.5 – 5.5
$2,000,000 5 +
*www.choicebizops.com/SDE_multiple.htm
Historical Perspective
Favorable factors that supported using a multiple higher in the range included:
Historical Perspective
*www.choicebizops.com/SDE_multiple.htm
ResourcesWeb Sites
www.sba.gov
www.investopedia.com
www.irs.gov
www.sec.gov
www.bls.gov
www.census.gov
www.stat-usa.gov
www.bizterms.net
www.bloomberg.com
www.nasdaq.com
www.nyse.com
www.bizcomps.com (pay)
www.bizminer.com (pay)
www.valuationrresources.com (pay)
www.commerce.gov
Thank you!
