Basic Business Appraisal

Basic Business Appraisal

  • Intended Learning Outcomes
  • Distinguish between real property valuation and business valuation
  • Describe the characteristics of the various business entities
  • Explain the business appraisal process
  • Describe the problems associated with accounting principles
  • Describe the steps in the analysis of financial statements
  • Describe the elements of a balance sheet and an income statement
  • Describe and calculate current ratio, quick ratio, inventory turnover ratio, debt-to-worth ratio, and net-profit-to-owner capital ratio
  • Describe the various approaches to business valuation
  • Distinguish among the different types of intangible assets and the techniques used to value intangible assets

 

Fundamentals of business valuation

In Florida, anyone assessing, marketing, or selling a business for someone else is required to have a real estate license. Many business brokers are required to do an extensive study to determine what a particular business might be worth. When comparing the steps required in valuing real estate to those in valuating a business, many similarities are obvious. Ultimately, the most common value that is being determined is market value.

There are, however, differences that must be noted if an effective business valuation is to be made. One significant difference is the educational background of a business broker. Most brokers who specialize in business opportunities have an accounting background. Unlike the average real estate broker, business brokers understand the in-depth nature of profit and loss statements, balance sheets, tax codes, and other financial analysis. In addition, business brokers must be able to determine the value of a business’s tangible and intangible assets.

Determining the Value of a Property
Determining value of a property is very important for a number of reasons. It is important to the seller in selling the property and it is important to the buyer in buying the property. Taxation requires notice of value and so does insurance.

The most exact way of determining value is with a state licensed and certified appraiser. To complete a real estate transaction, a certified appraisal must be used if the loan will be sold in the secondary market.

Another way of determining value is to do a CMA — Comparative Market Analysis. Real estate brokers and their associates do a comparative market analysis in order to let the seller know how much the property will probably bring on the open market. Brokers use a range in doing a comparative market analysis rather than one specific price. A broker cannot do an appraisal unless he or she is certified as an appraiser.

Types of Value of property:

Assessed value: Used by local and state governments as a means of establishing taxes.
Going Concern Value: The value of a currently operating business concern that is greater than the value of the property because it is an established business
Insurance Value: The value of a property for insurance purposes, usually in replacement cost but also considered in co-insurance clauses.
Investment value: The value to an investor who determines his rate of return and the net operating cost.
Liquidation Value: The value of the property in today’s market if sold quickly.
Salvage Value: The amount of value that a property is given at the end of its economic life
Value in use: The value of the property in its current use, rather than the highest and best use.
Market value: The most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

Business Appraisal Definitions
Proprietorship

A sole proprietorship is a business owned by a single person. The business may have a fictitious name and, if it does, it must be appropriately registered under the Florida Fictitious Name Act.

Partnership

Ownership of two or more individuals who carry on business as co-owners. A tax benefit for a partnership is that the partnership itself does not pay taxes but must form a partnership information return. The individual partners must pay income tax.

Corporation

A legal entity of ownership consisting of at least one person or more but has a personality of one (acting as one). A corporation exists forever unless it is dissolved by legal proceedings. It has a board of directors and shareholders. The corporation is a separate entity and therefore carries with it limited liability protection for its owners or stockholders. It has perpetual life and is a tax paying entity. Double taxation is a potential negative feature as earnings are taxed at the entity level and then taxed again when distributed to the stockholders as dividends.

Other Forms of Business

Other forms of business entities that can be formed include Limited Liability Companies, Limited Liability Partnerships, and Professional Associations. These are all created by filing with the Florida Department of State. In addition, there are some businesses that operate as a trust or in a non-profit status. Business brokers must be able to identify these types of business entities and understand the specific tax codes that apply to them.

Reasons for a Business Appraisal

A business appraisal may be done for a variety of reasons. Here are some of the reasons:

A buyer is contemplating the sale or purchase of an existing budget. Either the buyer or the lender or both may request an appraisal of the business to obtain a business loan.

Allocation of value to specific assets is done when only a portion of the business is for sale. For example, suppose that a communication company has a cell phone division for sale. The appraiser would specifically value the cell phone division in comparison with the value of the entire company. By doing an allocation of value, the owner of the business is aware of how much each part of the business is worth.

Financial reporting purposes: When a business owner has to make financial reports to the lending institution, a business appraisal is helpful.
Buy-sell agreements as in a merger or acquisition require knowing the full worth of the business.

Liquidation of a business can be for a number of reasons, including the discontinuance of the business. The partners or corporation stockholders will need to know the value of the business as it is liquidated to determine how much they will receive.
Divorce may mean the disclosure of the net worth of one of the owners to his or her spouse.

Estate and inheritance taxes are required under some circumstances upon the death of an individual. The value of the business is calculated into the estate of the deceased as the basis for taxation.

Condemnation proceedings require just compensation to the owners from the government taking the property. A business appraisal can help an owner determine if he is getting just compensation or if the owner must sue to get it.

Employee benefit plans take into consideration the market value of the business as the employee benefits package is being determined.
Determination of insurable value means the insurance company will want to know the market value of the business to set the policy. A comprehensive business insurance policy is important to small business owners and the plan should include insurance for interruption of business as well as a partial and complete loss under the policy.

Business Valuation Process

Valuing a business is very similar to valuing real property. There are six steps in valuing a business:

Definition of the assignment

The first step in ascertaining the value of a business is to define the problem (assignment). The business broker should first establish the purpose of the assignment. Market value will require a different methodology than in determining what interest is involved in the evaluation. This includes all assets, liabilities, and the owner’s equity position. In addition, establishing market value will require a different methodology than establishing liquidation value or investment value.

Establish the date of the appraisal

A business valuation establishes the estimated worth of a going-concern operation as of a particular date. In most cases, the date of the appraisal represents the value as of that date. The business broker must also be able to value a business for a time prior to the date of the report for probate estates.

Data collection

The business broker should be prepared to obtain profit and loss statements, balance sheets, and income tax records of business over the past three to five years (when possible). The broker must become familiar with the business and the type of product or service provided. The primary source of the type of data comes from personal interviews. A secondary source of information can be found in reports or other published materials.

Analysis of data

The final value of a business can be done only after a thorough analysis of the pertinent data collected. The broker may be required to adjust the business’s financial statement and other reports to obtain a true assessment of the operation. Many times pro forma income statements and financial ratios are used to accomplish this task.

Determine the final estimate of value

The final value conclusion of business is developed from analyzing the data collected. It is the culmination of the broker’s experience in the market and skill in collecting and analyzing the pertinent information that ends with the final estimate of value.

Preparation of the appraisal report

It is important for the broker to effectively and accurately communicate the results of his or her findings. A business valuation report should contain the following information:

Summary of facts and final conclusion
Purpose of the valuation report (e.g. market value)
Define the value estimated
Description of the business appraised and process used
Effective date of the value estimate
Summary of facts (based on collected data)
Statement of conclusions reached
Assumptions and limiting conditions
Supporting data (maps, exhibits, etc)

Understanding and Using Financial Statements

Overview of financial statements

Financial statements are the records of the life blood of a business. In this way, a business varies greatly from the sale of commercial or residential real property because there are a number of types of financial statements and a variety of ways that the data is presented.

Hopefully, a business will have income tax statements from the last three years, income and expense statements for the last three years, as well as a company balance sheet and any ledgers needed to support the information.

Check list:

Income tax statements;
Income and expense sheets;
Current inventory lists;
Current list of liabilities and assets;
Current information on bank loans;
Current information on payroll expenses.
These are just some of the items that an appraiser may wish to use as he or she looks at the value of the business.

Good records make the appraiser’s job easier!

Understanding and Using Financial Statements
Some problems

If an accountant or bookkeeper has been used, the business should use generally accepted accounting practices (GAAP). Even with general accounting principles, it is possible to run into a series of problems with the accounting systems. Here are some of the more notable problems:

Estimates are necessary. Some items, such as income taxes or payroll taxes, will need to be estimated because it may not be the proper time to pay these expenses.

Assets are reported at cost. Assets change value just as property and business do. The assets should be counted at the market value today rather than what the owner paid for the assets at the time or what the depreciated value should be.
Valuation accounts do not reflect value. Items such as depreciation and amortization should be taken into account and the current market value of assets should be used.

Assets and liabilities are missing. Vague items, such as relationship to a specific vendor or patents, copyrights, etc., may not be shown on the balance sheets and this gives an inaccurate understanding of the value of the business.
Differences in accounting methods are permitted. Even though general accounting methods are used, the accountant or business owner may use different forms of accounting devices, which means that the appraiser must be very careful to make sure that the data is comparable from all the sources. For example, there is a financial difference on an income sheet between “cash”, versus an “accrual” accounting system. If these two different accounting systems are used it means the final numbers at the bottom of the page will not match.

Analyzing financial statements
One obvious problem associated with Generally Accepted Accounting Principles is that real income and reported income will be different. There are several steps that should be taken to insure that the data used accurately reflects the real economic condition of the business.

The initial step in analyzing financial statements is to develop a historical financial statement. This will involve collecting balance sheets and income statements for the past three to five years. Income tax returns may also be useful particularly for smaller business opportunities.

Calculate financial ratios over time
The second step will be to apply various financial ratios to the data that was obtained during the initial step. The following ratios will assist the business broker in determining any problems that may be associated with a business and provide a better understanding of the operation’s true financial condition. The following are ratios that should be considered when analyzing a business’s financial position:

Quick: The quick ratio compares a business’s current assets to current liabilities. This ratio is sometimes known as the “acid test” which measures the business’s ability to meet a short-term obligations. Current assets can be defined as cash, securities, and accounts receivable that can reasonably be expected to be converted into cash or absorbed in the operation of the business within a relatively short period of time, usually one year or less. Inventory is excluded as an asset in the quick ratio but is used when calculating the CURRENT RATIO. Current Liabilities are those debts and obligations which are due within one year and usually are expected to be paid from current assets.

Current Assets minus Inventories / Current Liabilities = Quick Ratio

_Current Assets / Current Liabilities = Current Ratio

Inventory Turnover: The inventory turnover ration is used to determine how quickly inventories move through the company. It is calculated by dividing the cost of goods sold by the ending inventories. The income statement is the source of information for this ratio.

Cost of Goods Sold / Ending Inventory = Inventory Turnover Ratio

Debt-to-Worth: The debt-to worth ratio provides a quick measure of total indebtedness relative to the value of the equity position of the owners. It provides an understanding of the business’s ability to borrow money (leverage). It is calculated by dividing total liabilities by the net worth of the business. Net worth, in this calculation, is all tangible assets excluding all intangible assets (goodwill, franchises, etc.).

Total Liabilities / Net Worth minus Intangible Assets = Debt-to-Worth Ratio

Net Profit to Owner: The net profit to owner ratio is computed by dividing the before-tax cash flow by the tangible net worth of the business.

Net profit before taxes / Tangible Net Worth = Net Profit to Owner Ratio

Investigate unusual items and results
The final step in analyzing financial statements is to investigate unusual items that were discovered when working the various financial ratios. The business broker should be searching for the truth regarding a business’s financial condition. Items that might be red flags include increases in miscellaneous incomes over the evaluation period, unusual receivables, deferred maintenance, tenant concessions, and a slowing of the inventory turnover ratio. Typically, owners want to maximize the appearance of profitability if they are selling a business.

Preparing financial statements for valuation purposes
The purpose of analyzing the financial statements of a business is to estimate market value. The analysis of data collected will assist the business broker in developing an adjusted balance sheet, a market balance sheet, an adjusted income statement, and a pro forma income statement. The combination of this information, along with the broker’s knowledge and understanding of the market, allow a final value conclusion to be made.

An adjusted balance sheet excludes items such as intangible assets, assets that are outside normal business operations, and other items might give a false interpretation of the financial condition of the business.

A market balance sheet restates the owner’s equity position as it relates to tangible assets at market value. Items that are typically adjusted for the market balance sheet include 1) accounts receivable which readjust bad debt more accurately, 2) inventory at market value, and 3) equipment and machinery at market value, not book value.

The adjusted income statement is structured to eliminate all items that may distort or skew the true financial position of the business. The business broker will use comparable business to establish market trends in this regard.

The PRO FORMA INCOME STATEMENT projects future cash flows based on current and historical data of the business. This is considered the most important statement used in estimating a business’s value based on income.

Valuation Methods
Approaches to valuation

The approaches the appraiser uses are:

The Sales Comparison Approach will use data from any comparable businesses that have sold in the area in the previous year to get comparable figures to determine market values.
The Cost-depreciation Approach is somewhat unreliable due to the flexibility of sales over years and the value is more dependent on sales than on assets.
The Income Approach needs reliable figures upon which to base projections like a pro forma. Cap (capitalization) rates should be appropriate for the type of business that is being considered. After obtaining the net income, divide the income by the cap rate to determine the market value of the business.
The Liquidation Value Approach means that if the firm were to shut down suddenly today, the result on the market would be liquidation value, usually done quickly and for a conservative amount. How much would this business bring in, in an emergency sale? This is the question used by the appraiser in this type of value study.

Valuation of intangible assets
Definitional problem with intangible assets

Business brokers must be able to evaluate not only tangible assets but intangible assets also. There are three categories of intangible assets: 1) Business Goodwill; 2) Personal Goodwill, and 3) Separable Intangible Assets. Determining the value of an intangible asset requires knowledge and experience beyond the capabilities of the average appraiser.

Business Goodwill: Business goodwill represents the value of the reputation of a business. This value is a combination of consumer satisfaction, marketing accomplishments, and expected growth.

Personal Goodwill: Personal goodwill represents the value of the reputation of the owner or employees of a business. Personalities and special talents can hold a value that is difficult to determine.

Separable Intangible Assets: Many assets can be categorized as separable intangible assets. They include licenses, trademarks, copyrights, and franchises.

Methods of Valuation
The appraiser has two choices of valuation: the Excess profits Approach and the Market Residual Approach.

Both of these approaches determine the value of tangible assets, find the value of intangible assets and estimate the value of a business and personal goodwill.

The Excess Profits Approach: uses the return on investment (the capitalization rate) that an investor would require, and then the appraiser applies that rate to the tangible assets value. This becomes an income that would come from those assets. He deducts this income from the total net operating income; the balance becomes the intangible asset value. He then multiplies the cap rate times the intangible assets value to obtain the value of all.

The Market Residual Approach: first values the tangible assets, and then subtracts this value from the total value of the business. This leaves the intangible assets. The appraiser then estimates the value of the intangible by dividing net income from these assets by the cap rate. Goodwill value is anything left after the tangible and intangible assets value income is found.

Steps in the Sale of a Business
To sell a business the following steps are usually taken:

The broker lists the business for sale.
All the assets and liabilities are noted that belong to the business.
Value for the business is established, using some or all of the methods.
Subtract the liabilities–short and long-term–from the value of the business.
Check to see if the business is a corporation. If it is, divide the value by the outstanding shares.
Market the business.
Find a buyer and obtain a purchase agreement.
Arrange for closing and close the transaction

Summary

The difference between a real property valuation and business valuation is the educational background in finance of a business broker, and business brokers must be able to determine the value of a business’s tangible and intangible assets.

The characteristics of the various business entities are 1) sole proprietorship is individual ownership; 2) general partnership is two or more individuals in business sharing in the profits and losses, and 3) corporations are owned by stockholders and must be created by filing a charter with the Department of State.

The six steps in the business appraisal process are 1) Define the problem; 2) Establish the date of the appraisal; 3) Collection of data; 4) Analyze the data; 5) Determine a final estimate of value; and 6) Preparation of the appraisal report.

Problems with Generally Accepted Accounting Principles (GAAP) include:

Estimates may differ regarding actual incomes.
Assets are reported at cost and not at their current value.
Business brokers calculate reserves for depreciation and amortization, which impacts the cash flow of a business and, ultimately, its value.
Certain assets and/or liabilities may be missing or omitted.
The steps in the analysis of financial statements are:

Develop a historical financial statement.
Apply various financial ratios to the data that was obtained during the initial
step, including the Current Ratio, Quick Ratio, Inventory Turnover Ratio,
Debt-to-worth Ratio, and Net Profit to Owner Ratio.
Investigate unusual items and results.
The elements of a balance sheet include assets, liabilities, and owner’s equity. Elements of an income statement include gross revenues, expenses, and net revenues.

The calculations for the financial ratio are:

Current Assets minus Inventories / Current Liabilities = Quick Ratio

Cost of Goods Sold / Ending Inventory = Inventory Turnover Ratio

Total Liabilities / Net Worth minus Intangible Assets = Debt-to-Worth Ratio

Net profit before taxes / Tangible Net Worth = Net Profit to Owner Ratio

The four approaches to business valuation include:

The Comparable Sales Approach
The Cost Depreciation Approach
The Income Capitalization Approach
The Liquidation Value Approach (unique to business valuation)
The three types of intangible assets of a business are:

1. Business Goodwill (business success)

2. Personal Goodwill (individual success)

3. Separable Intangible Assets (franchise)

The two methods of valuing an intangible are the Excess Profits Approach and the Market Residual Approach

Vocabulary List: accrual basis accounting, balance sheet, book value, cash basis accounting, current ratio,
debt-to-worth ratio, going concern value, goodwill, income statement, intangible asset, inventory turnover ratio, liquidation value, market value, quick ratio, S corporation

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