Have you ever asked yourself: how will I ever clean up this financial statement mess for a business valuation? You are not alone. Many small companies have notoriously improper financial records and error filled financial statements. This is often caused by a lack of understanding of what is required to have proper financial records. It is also caused by the drive to keep overhead as low as possible, which is an admirable goal that sometimes goes too far. If the company is profitable, the owner and management may get away with sloppy records until they need to apply for a bank loan, add a partner, or perhaps sell the business; or they need a business valuation for another reason.
One of the primary differences between valuing micro and small businesses and larger businesses is the quality of financial statements. Larger businesses tend to have reviewed financial statements at the very least, while many have audited statements. These businesses have true accounting and financial departments and people with the skills to keep proper GAAP records– or at least to understand and report the variances.
One of the nice things about running a small business is you get to run it your way. But, when third parties need to review your financial statements, you need to do it their way, at least to a certain degree. Here are some ways to get these financial records in shape for someone else to use them.
Know the limits of cash basis accounting.
Cash basis accounting is one of the most common things we see with small businesses. This is an accepted method of accounting, but it might not give useful financial information for many purposes. Cash basis is particularly prevalent on tax returns used to value small businesses since the cash basis better aligns tax liability with the receipt of money to pay the taxes.
For example, if the company being evaluated has large accounts receivables but the timing of collection varies, it can be difficult to get a complete picture of the true underlying cash flows. This is because accounting periods have end dates, but ongoing businesses do not have end dates. Each of these accounting period end dates represents a cut-off, but we don’t know what happens the next day. An income statement that ends on December 31 will not show a huge receivable collected on January 5, and therefore is not a complete picture.
Be aware of outright accounting errors.
Outright errors on company financial statements present another issue for business valuation of a small company. The valuator or other reviewer must always be on the outlook for material errors. Usually these errors are accidental, but may not always be. Errors often even show through on tax returns prepared by third party tax preparers. Some common errors are:
Overstating the cost of goods sold and understating inventory. This practice reduces profit and therefore taxes. Often companies only overstate a small amount of goods sold each year, but over time this can become a big problem. Take a small retailer with $300,000 of inventory and $90,000 of profit each year for example. If they overstate the cost of goods sold by $30,000 for 10 years on their tax return, by the tenth year, they will not have any inventory for tax purposes. However, they would still have $300,000 of inventory on the floor and in the back room. They will have also understated profits by $30,000 per year, or 25% per year–a significant percentage. Over the 10 years, they will reduce profits by $300,000. This can create both valuation and tax problems if discovered.
Failure to show inventory at all. This just creates a complete mess for inventory rich small businesses. In many cases, it leaves the company unable to be valued, obtain a loan, or be sold.
Failure to write off un-collectable accounts receivable under the accrual method. Some businesses never write off uncollectable accounts receivable. This causes income to be overstated. This is usually fairly easy to adjust if underlying data about accounts receivable is properly tracked.
Expenses being recorded under a variety of names. We have seen office rent shown as rent expense, mortgage payments, and lease expense all in the same year for the same company. Those types of errors make it hard to review the data for consistency and figure out what the real amount is if an account needs adjustments.
These are just a small sample of accounting errors that impact financial statements and tax returns used in business valuation of small businesses. As the old computer programming adage goes, “Garbage in – garbage out.” In most cases, with care we can clean these mistakes up and feel comfortable that the financial statements reasonably represent the company that is the subject of the business valuation. But in some cases, we may have pure garbage that may make giving an opinion of value in a business valuation impossible.
I’m a JD, CPA and Certified Valuation Analyst, and I know that business valuation is both an art and science. To find out more about professional valuation services for your business, contact me to learn more.
The Value Examiner® is an independent, professional development journal dedicated to the exploration of value and its ramifications for consultants published by NACVA (National Association of Certified Valuators and Analysts)
I am pleased to announce that I have been chosen to write a column on Small and Micro Business Valuation issues for “The Value Examiner” starting with this most recent edition.
In “Size Matters -Valuation of Small and Micro Businesses”, I will focus on matters of particular importance to businesses under $10M in revenues.
In the November/December issue, I present a case study of a recent valuation of a general contractor with a 6/30/2020 valuation date, near the peak of uncertainty from Covid-19.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has 400 pages covering many professional judgement, calculation, standards, and other important valuation issues along with access to sample reports, calculators, and checklists downloadable from the web. This will be the one book you will reach for if you value or rely on valuations of micro or small businesses with revenues under $10 million. The book published by Wiley is available at your preferred bookseller. More information can be found at www.theartofbusinessvaluation.com
Finally Greg Caruso, JD, CPA, CVA, the author is always available to prepare (or review) business valuations for all purposes and situations.
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After a recent seminar “Valuing Small Businesses in the Shadow of COVID-19”, I took time at the end to answer some questions from the attendees. Here are some of the questions (and answers!) on using the Income Method to value small businesses that I felt might be most helpful for other seminar attendees as well as business valuators, CPAs, lawyers, and consultants that work with business valuations.
Do you believe projections and forecasts for the discounted cash flow income method of business valuation use will be less reliable during the Covid-19 Pandemic than before?
It is very difficult to estimate reliability of projections for business valuation outside of comparing a company’s prior projections with actual results. Most small companies do not have that type of data or the projections prove to be unreliable pretty much all the time. Therefore I do not believe most projections are less reliable due to COVID-19. There are reasons to believe they may be more reliable. I suspect in most cases much more thought and support will be provided in creating the projections and final forecast. For many companies, instead of being a “add 5% to last year” situation (we have all done it) much more strategy and foresight will go into the whole planning and projection process.
In all events all projections and forecasts for use in an income method of business valuation need to be reviewed carefully from the point of view of, “is this the absolute best that can be done” with what is known and knowable. In the “The Art of Business Valuation”, much time is spent on reviewing projections as it is always a difficult area with a high level of professional judgment.
Aswath Damodaran models deal with changing growth rates and discount rates in the future in order to estimate business value using the discounted cash flow income method. See his discussion of the three state dividend discount model and the H model. Do you agree?
Damodaran is clearly a sage in the field of business valuation. He deals almost exclusively with public and extremely large private companies that may go public. That is entirely different from valuing small and micro businesses typically with revenues under $10 million. Certainly if you are working with a company that can provide a quality projection as a base for use in a discounted cash flow analysis, adjusting the cash flows and the discount rates over time is a reasonable way to estimate the value. In fact, if the data is highly supportable, the discounted cash flow method is theoretically the best method. Of course this is fact and situation dependent like all business valuations.
Many Companies and most small companies cannot give you a reasonable starting point projection or forecast. From my point of view, if I do not have a reliable projection to start from, it is usually best to use a single period valuation method such as the capitalization of earnings method with proper adjustments. Therefore in the proper situations, I agree with Damodaran. But for most micro and small business valuations we will not have the starting point data available to us to use the discounted cash flow income method of business valuation.
On last comment. I will frequently run estimated discounted cash flow models with various potential earnings streams to get an understanding of a companies range of values under possible scenarios. But to me, these are sanity checks and/or information underlying my professional judgement not final valuation methods. A useful tool but if I can’t really support the cash flow, it is not a final valuation method.
Have you ever had a situation where the Company Specific Premium in the Income Method of Business Valuation is negative because risk is lower than normal?
Absolutely but it is quite rare. Every now and then we find a company that is so locked in with its customers (often referred to as “sticky” ; for example, credit card processors can be sticky because they are written into your website) and so well organized and profitable that the risk is below the average public company. But, that is very rare. If you find that company, make sure you really build a well thought out case for your adjustment because it is likely to be doubted. Clearly explain why your company is different and why it should stay that way in the foreseeable future.
More webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic and other business valuation topics are being scheduled in the upcoming weeks. If you are interested in participating, please visit our Upcoming Events page
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book, published by Wiley, is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Recently I presented “Valuing Micro and Small Businesses in the Shadow of COVID-19″ as a webinar training for Business Valuation Resource members. As always, I provided time at the end of the session for questions from attendees. This group had some very thoughtful questions. I thought perhaps others would benefit from our discussion.
What do you mean by “poor financials?” Do you mean a lot of personal stuff is run through the business? Or a general ledger that doesn’t balance and off balance sheet assets / liabilities?
Each of those issues creates poor financials plus many more. Many micro and small business owners manage by walking around. They have a few leading indicators they watch (maybe sales, collections, production). From those, plus being in the middle of the business, they know how they are doing. This knowledge does not translate well for us, as we are not in the middle. Therefore, we have to work harder to really understand what is going on and how to adjust the deficient financials so they are reasonable and workable.
What sources of data do I use for the local economy?
I use the Federal Reserve Beige Book, published for each district. It is anecdotal information but I find it useful.
Another one I will use for cyclical and real estate related is State Board of Realtors sales data. Often this can be obtained at a local level, if that is more meaningful for your company. The data here impacts everything from construction, remodeling, furniture sales, equipment sales, etc. in a local or state market.
Also, the quarterly BizBuySell Insight Report offers data on many market areas with prior reports available for many years to allow comparisons. The number of sales can be used as an indicator of the difficulty or ease of selling a small business.
Local information can be gleaned from many sources. Many federal agencies, states, universities, and state oriented non-profits publish data that might be indicated for the Company and industry you are valuing.
I have been spending more time analyzing debt service (for example: Can they pay back the debt? If so when will they achieve a profit given high debt levels? Will they need more debt to stay afloat?). Do you have any thoughts on that?
Certainly for high debt companies, or companies with lumpy cash flows, (i.e. a few large clients or projects that have endpoints like construction contractors that do a few large projects each year) understanding the balance sheet is very important. Current assets on the balance sheet (particularly cash reserves) provide resiliency and the ability to meet payments when times are tough.
Another thing that needs to be reviewed with companies with debt is the terms of the debt. Many small companies use lines of credit like long term financing. Also, even long term loans often contain clauses allowing the lender to recall the entire amount due, if covenants like minimum earnings are not met. The result can be a company that is meeting minimum cash flows to survive falls into default on their loans creating serious going concern issues.
In most cases (but not all), we do not have data to make a final determination on going concern issues. But a company that has a reasonable level of going concern issues is going to have a steep discount versus companies with a clear path forward.
I saw a few companies with low, negative earnings (-30% to 50% and high revenues multiples in the range of 3-4x. This looks funny for a service company. Since I don’t have historic data or projected data how can I make sense of the pricing relationship?
Without more data, I’m not sure. And perhaps you can’t. Some technology codes do have the types of companies desired by Google, Apple and the like and these may contain synergies that frankly I don’t completely understand how to assess.
Assuming there are enough comparables, I recommend several things though before you throw up your arms in defeat.
Try sorting the data several ways. Use different cash flow minimums and minimum and maximum revenues and see if the results look different. Sometimes I get an understanding of the data doing this and it is easy within the DealStats .
Assuming your firm is profitable sort with a minimum cash flow that is somewhat near your cash flow (i.e. if your company as a 15% SDE profitability (SDE/Revenues) and a minimum revenue sort of $1,000,000 then perhaps you require an SDE of $75,000. Since your company is profitable, these comparables will be more like your company.
Always chart the companies by cash flow profitability (Cash flow being used/Revenues). This will usually provide clear trends that are different from what might be implied by the charts shown in the various databases.
Three more webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic are scheduled in the upcoming weeks.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Greg is available for interviews, podcasts, quotes, presentations and more. Contact Greg at or 609-664-7955.
