Driving Your Company's Value

Understanding Your Financial Statements – Part 12: Stockholder’s/Partner’s Equity or Owner’s Net Worth

Stockholder’s Equity represents the funds (money) that the investors have invested in the company for the long haul.  Common accounts in the stockholder’s equity section include: Preferred stock, common stock, paid in capital, treasury stock, and retained earnings.

The stockholder’s equity section has different names depending on the legal entity.  In a partnership it is known as Partner’s Equity, in a Limited Liability Corporation it is known as the Member’s Equity section, and in a sole proprietorship it is known as Owner’s Equity or Owner’s Net Worth.

Financial statement analysis questions that should be asked related to the company’s stockholder’s equity include:

1. Is your stockholder’s equity increasing or decreasing as compared to the prior period or previous year?  What are the factors that caused the change?
2. Does your increase in equity from profits reflect the owner’s fair market value salary or is it overstated because the owner was not paid a fair market value salary?
3. Stockholder’s equity represents the percentage of total assets (stockholder’s equity divided by total assets)?  How does it compare to the prior period or prior year?  How does this compare to industry comparative data?
4. If the company has had an investment in the company from selling stock, was it necessary to keep the company from going bankrupt or to support planned growth?
5. Does the company need additional capital to be invested in the company?
6. Should the company be paying dividends to its stockholders?  Can the company afford to pay dividends or make distributions to its stockholders without negatively affecting the company or slowing down its growth rate?  Does the company have excess cash reserves that can be distributed to the stockholders?
7. Should the company repurchase stock from the stockholders to increase its return on equity and to allow the investors to make alternative investments with the excess cash from the distributions?
8. Does the company have any convertible preferred stock? If so, is it likely to be converted into common stock?  What affect would the conversion have on the equity section and the value of the underlying common stock?
9. Does the company have any cumulative dividends on preferred stock due to preferred stockholders?  If so, have the dividends been accrued on the books or calculated on a schedule? 

Understanding Your Financial Statements – Part 11: Long Term Liabilities

Long term liabilities represent the debts of the company which will not have to be paid within the next twelve months.  These liabilities commonly include:  bank debt, loans from stockholders or related entities and contingent liabilities.  The portion of the liability that has to be paid within the next twelve months is recorded in the financial statements as part of Current Liabilities (See Part 10). 

Financial statement analysis questions that should be asked related to the company’s long term liabilities include:

1. Are your long term liabilities increasing or decreasing as compared to the prior period or previous year?  What are the factors that caused the change?
2. Long term liabilities represent what percentage of total assets (long term liabilities divided by total assets)?  How does it compare to the prior period or prior year?  How does this compare to industry comparative data?
3. Do you have a good relationship with your banker and other creditors?
4. Should you consider restructuring your interest bearing debt to change lengthening your repayment schedule?
5. Should you consider repaying your debt sooner to lower your future interest expenses?
6. What is percent of your payments or principle versus interest?
7. Can you accelerate your principle payments without having a significant negative impact on your operations?
8. Have you set goals for the level of debt you desire to maintain?
9. Do you plan to repay debt from related parties (stockholders or other related parties) or is it really a form of equity (long term debt without FMV interest being paid)?  If so, should the debt be reclassified to equity?
10. Are there any balloon payments that need to be paid in the next two to three years?

Ratio Analysis, Part 9 – Accounts Receivable Turnover Ratio (cont)

I previously reviewed the A/R turnover ratio, as well as the related average collection period. Let’s digress just a little…

Most of my discussion regarding financial ratio analysis has been oriented towards spotting trends or issues. Typically, financial ratio analysis is performed after-the-fact, or on historical financial performance. Therefore it is easy to assume that financial ratio analysis is merely diagnostic in nature…it is used to look for a problem to fix or to keep a problem from occurring.

Let me make just two comments:

1. Financial ratio analysis can, and should be applied to financial forecasting. Doing so provides a ‘sanity check’ as to the reasonableness of the forecast. For example, if your company has had a historical gross profit margin of 35 percent and your forecast shows a 45 percent gross profit margin, you better have a damn good explanation for the dramatic change…otherwise both you and your banker will be disappointed.
2. Don’t let the tail wag the dog. What I mean is that financial ratios are a tool to help you manage and direct the business, not shackles that keep you from doing what you need to do to accomplish your business and personal goals.

Regarding the second point, the average collection period is a great example. My prior discussion identified the reasons, or effects, of changing average collection periods. However, one way to grow revenues (and hopefully profits) is to loosen credit standards – providing more generous payment terms to your customers will (1) allow existing customers to purchase more from you, and allow new customers with poorer credit history to purchase from you. That’s not necessarily bad…as long as you understand the risks involved.

This type of risk (credit risk) is what bankers deal with every day, usually very effectively, but sometimes not too well, as the current subprime mortgage mess illustrates.

There is a cost to you to purposefully allow the average collection period to grow. You diminish your cash by allowing customers to pay later and you risk greater levels of non-payment by having customer with poorer paying records. You may even have to borrow to finance your receivables to do so. You need to recognize this fact and you measure and track it.

So, if you put this all together, you can be proactive in your receivables management and possibly grow your business through use of credit terms. However, you should do so only if you can estimate the cost of doing so and you carefully and constantly measure and track your strategy, in part, through the use of both historical and prospective financial ratio analysis.

Ratio Analysis, Part 8 – Accounts Receivable Turnover Ratio (cont)

The traditional formula to calculate the A/R turnover ratio is:

Sales ÷ Accounts Receivable

Accounts Receivable can be measured either at period end, or an average over the sales period.

We can convert the A/R turnover ratio to an A/R collection period or Average Collection Period as follows:

Average Collection Period = 360 ÷ A/R Turnover Ratio

How do we interpret this ratio?

Implications of an increase in Average Collection Period:
• Company’s customers might be in trouble
• Possibility for an increase in write-offs
• Reduction in cash on hand

Implications of a decrease in Average Collection Period:
• Increase in cash on hand
• Increase in operating cash flow and free cash flow
• Increase in Return on Equity

Implications of a high Average Collection Period:
• High cost in extending credit to customers
• Loose credit policy
• Less cash on hand

Implications of a low Average Collection Period:
• Tight credit policy
• More cash on hand

Ratio Analysis, Part 7 – Accounts Receivable Turnover Ratio

I have been reviewing turnover ratios. Turnover ratios can be used to measure efficiency of operations and management. In addition to considering total asset turnover, we can measure and evaluate efficiency of any single asset or group of assets. We looked at the inventory turnover ratio. Now let’s look at the accounts receivable turnover ratio (or A/R turnover ratio).

The traditional formula to calculate the A/R turnover ratio is:

Sales ÷ Accounts Receivable

You could also use “average” accounts receivable, similar to how we previously calculated the average inventory turnover ratio.

What does the A/R turnover ratio tell us? How quickly a company gets paid by its customers. So, if a Company as an A/R turnover ratio of “12,” that implies the company is paid by its customers in 30 days, on average. This leads to an expansion of the formula, converting the A/R turnover ratio to an A/R collection period or average collection period.

Average collection period is calculated as follows:

Average Collection Period = 360 ÷ A/R Turnover Ratio
     Note: You could also 365 days

So let’s assume a company has $4.2 million in annual sales and $525 thousand in accounts receivable at year-end. That calculates to an A/R turnover ratio of 8 times (or 4,200,000 ÷ 525,000). The average collection period is 45 (or 360 ÷ 8)

It should be obvious that the more quickly a Company gets paid on its credit sales (the higher the higher the A/R turnover ratio and the lower the days sales outstanding), the more cash is available to it. Next time, we’ll talk about how to interpret and use the A/R turnover ratio.

Understanding Your Financial Statements – Part 10: Current Liabilities

Current liabilities represent the debts of the company which will have to be paid within the next twelve months.  This is similar to current assets in that it represents items that will affect the company’s cash flow in the next 12 months.

Current liabilities commonly include:  accounts payable, salaries payable, accrued expenses, income and payroll taxes payable, and the current portion of notes and mortgages payable.

Financial statement analysis questions that should be asked related to the company’s current liabilities include:

1. Are your current liabilities less than your current assets?  Is this a change from the prior period or previous year?  What are the factors that caused the change?
2. Current liabilities represent what percentage of total assets (current liabilities divided by total assets)?  How does it compare to the prior period or prior year?  How does this compare to industry comparative data?
3. Should you consider a long-term bank loan or additional capital (money) investment in your company to lower your current obligations? 
4. Do you have a good relationship with your banker and other creditors? How will any changes in current liabilities affect that relationship?
5. Do you pay down your line-of-credit to zero at least once a year?  If not, should you consider a long-term bank loan or additional capital (money) investment in your company? 
6. Do you have payroll taxes payable?  If so, are you facing penalties for late payment?
7. Are you depending on short-term loans to support your company?

Ratio Analysis, Part 6 – Inventory Turnover Ratio (cont.)

Analyzing and understanding financial ratios aids in the evaluation of a business’ performance, either against itself over time, or as contrasted with the business’ industry and/or peers. In the last part of this series I illustrated the purpose and calculation of the Inventory Asset Turnover Ratio. The formula is as follows:

Cost of Goods Sold ÷ Average Inventory

How do we interpret this ratio?

Implications of an increase in Inventory Turnover:

• May indicate rapidly rising prices or shortages
• Advanced sales (temporary jump) or discount-driven sales
• Increasing operating cash and free cash flows
• Increasing return on equity

Implications of a decrease in Inventory Turnover:

• May indicate rapidly dropping prices or surpluses
• Decreasing operating cash and free cash flows
• Decreasing return on equity

Implications of a high Inventory Turnover:

• Well selling product(s)
• Effective buying practices
• Effective inventory management
• High operating efficiency
• Increase cash flow
• Reduce warehouse and other related costs
• Company may have too little inventory
• Possibility of lost profits due to delayed customer orders

Value from an Investment Banker's Perspective - The 2nd in a Series

Intangibles, and How They Influence Market Value

Investment bankers deal in the real world of MARKET VALUE, but no value is established until a transaction takes place-a check is written, the contract for services and the earn out is negotiated and agreed to by all parties. We know from experience that all transactions, within a given industry, and for businesses of a certain size, have a range of value. That value is most often measured by a multiple of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Therefore, because there is a range of value as measured by a multiple of EBITDA, then there must be more to value than only EBITDA or there would not be a range.

Ignoring for the time being the differences in terms of the deals, and the variance of negotiating skills and competency (or lack thereof) of professionals on both sides of a transaction, the range of value can often be explained by the intangibles of the business. Intangibles are the aspects of the business that do not appear on the balance sheet but provide value to the business and influence the range of value as measured by EBITDA.

Let’s illustrate how important this can be for a business owner. Assuming a business is worth between 3.5 and 4.25 times EBITDA (and in most cases the range is substantially higher than this illustration) and assuming the EBITDA equals $1MM, the range of value amounts to $750,000 or a 21.4% premium. To a small or middle market business owner, this is significant and could amount to the difference between retiring in relative comfort and being able to achieve his or her personal goals, or not achieving them.

How can business owners obtain this 21% premium? We are often asked the most significant ways to improve value in a business. I have listed some of those intangibles below.

Ways for owners and managers to improve the value of a business through INTANGIBLES:

1) Provide for redundancy of management – acquirers do not want to buy a “one man shop.” There is too much risk associated with it and if competent management is in place, you increase the number of prospects to buy the business, thereby increasing the likelihood of obtaining a higher value. Owners should be able to take a three month vacation and come back to a better and stronger business than when they left. Work “ON” your business, not “IN” your business.

2) Cross-train your employees – this reduces risk and increases the number of buyers because you have a stronger business model.

3) Increase the business and financial literacy of all personnel in the company – if employees understand how their actions affect the bottom line (and what the bottom line really means) and how it affects them, they are more responsible in their actions and more productive. Employees are remarkably easier to motivate and manage when they understand the financial drivers of the company and financial transparency has been provided to them. This takes a commitment of resources, but will pay back ten fold in value and benefit to the company.

4) Implement and document systems – it takes the ambiguity out of daily activities. People will know how to handle situations and can “manage by exception” and not by emergency. Utilize customer resource management (CRM) programs, enterprise resource planning (ERP) programs, inventory control systems, sales and management, financial and accounting systems and document them all.

5) Diversify your customer and product base – don’t be overly concentrated in any one customer or product. Again, diversification decreases risk.

6) Have a written business plan in place and measure and compare financial pro forma with actual results. This allows your banker and a prospective buyer to see how the business is organized, how it makes money, how its profitability and cash flow can service debt and how value is created. It will also make it easier to sell the business based upon a higher future value.

7) Keep it simple – the business plan and model. If it is too complicated, the value of the business decreases.

If you address the above 7 points, you will have decreased the risk of your business and increased its value. You will have also lowered your cost of capital, which is a reflection of the perceived risk of your business, which increases value. You will have led to making some tangible improvements in value, such as increased free cash flow and increased asset utilization, which I will address through the “Value Formula” in the next article.



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Ratio Analysis, Part 5 – Inventory Turnover Ratio

Previously, we discussed the total asset turnover ratio. Turnover ratios can be used to measure efficiency of operations and management. In addition to considering total asset turnover, we can measure and evaluate efficiency of any single asset or group of assets.

Of course, calculating ratios is more than a mere mathematical exercise. It makes no sense to evaluate financial relationships that are irrelevant to a company’s business model.  For example, calculating an accounts receivable turnover ratio for a retailer that sells little, if anything on account reveals very little, if anything, about the quality and efficiency of operations of the business, either as against itself over time or when contrasted with some industry peer norm.

So, if we consider an inventory turnover ratio, what business models will such have most relevance? Those business models that include the acquisition and use of inventory. This could include retailers and wholesalers, who purchase and resell goods in a distribution chain, or manufacturers, who purchase raw materials and/or components, and fabricate and/or assemble the inventory into products for resale. In this latter business model, we could actually measure inventory turnover at multiple levels…raw materials inventory turnover and finished goods inventory turnover, for example.

The traditional formula to calculate the inventory turnover ratio is:

Cost of Goods Sold ÷ Average Inventory

Alternatively, it could be calculated as

Sales ÷ Average Inventory

When might you use the alternative formula?

• If gross margins are stable. If the business’ gross margins fluctuate, or if there is wide diversity of margins within the industry, then comparative and trend analysis of intenntory turnover relative to sales will reveal little.
• If it is industry practice to measure using sales, then in order to make an apples-to-apples comparison to peer data, so must you.

What does the inventory turnover ratio tell us? It indicates how many times in a reporting period the company sells its inventory. The more times a company can turn over its inventory at a specific level of operations, the more gross profit dollars are generated. Next time, we’ll talk about how to interpret and use the inventory turnover ratio.

Understanding Your Financial Statements – Part 9: Other Assets

Other assets are assets used by a business that are miscellaneous assets that may or may not be used in the business.  These assets are generally considered to last more than one year.  Examples of other assets includes: goodwill, intangible assets (intellectual property, etc), long term notes receivable, and non operating assets (cabins, investment properties, etc).

The effective use of your total assets is one of the three factors determining your return on equity.  As a result the effective management of other assets may directly affect your return on equity.  Investments in unnecessary assets such as cabins and other perks can occupy the company’s available cash which could be used effectively in the business.

Financial statement analysis questions that should be asked related to the company’s other assets include:

1. Other assets represent what percentage of total assets (other assets divided by total assets)?    How does it compare to the prior period or prior year?  How does this compare to industry comparative data?
2. What percentage of total assets do cabins, etc. represent as a percentage of total assets?  How does it compare to the prior period or prior year?  How does this compare to industry comparative data?
3. Have any investments in other assets been made in the last fiscal year end?  If so, have they been utilized according to your plan?  Has the increased level of return on investment been achieved?
4. Should you liquidate any unnecessary assets that are not being used effectively in the business?
5. What are your long- term plans for any assets not being used in the company’s operations?