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					Financial Statement Analysis and Business

Tim Miller, CLU, FALU, FLMI
Munich American Reassurance
Financial Analysis

                     Perspective U.S. Business

                 Financial Statement Analysis

 Income Statement            Balance Sheet        Ratios

                        Business Valuation
         Asset Based                    Earnings Based
Perspective on U.S. Business

 In 2002 total receipts for all
  U.S. firms was 22.8 trillion

 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.         2004 Census Bureau
  Census Bureau in 2004
  there were a total of
  25,409,525 businesses.

 Of that number 5,885,784                     Total
  were classified as employer                  businesses
  firms ( having a payroll ).
 Firms with 100 or more
  employees numbered only
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
 Income     Balance
Statement    Sheet
Financial Statement Analysis
      Balance Sheet

      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


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 Analysis
       Liquidity Ratios

•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 Analysis
       Liquidity Ratios

                                                    Cash and
               Quick                                Equivalents
•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 Analysis
      Debt Utilization Ratios

         Debt                          Risk                        Return

  • Finance                     • Risky                      • Increased
    Operations                    Capital                      Revenue
  • Business                      Structure?                 • Company
    Expansion                   • Overuse of                   Growth

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 Analysis
      Debt Ratios

                                               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 Analysis
      Debt Ratios

                                                   Total Debt
          Ratio                                    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

                                               Operating Profit
        Earned                                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 Analysis
      Profitability Ratios
Financial Statement Analysis
      Return on Equity



     •Rate of return relative to equity invested in business
     •Determines if business is making enough profit to warrant business risk
Financial Statement Analysis
      Operating Profit Margin


                                                 Net Sales

     •Measure profit per percentage of each sales dollar
     •Higher percentage more effective converting revenues to profit
     •Useful comparing
Financial Statement Analysis
      Return on 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
Financial Statement Analysis

 Read the notes attached to the statements:
Business Valuation
Business Valuation
      Book Value
Business Valuation
      Adjusted Book Value
Business Valuation
      Adjusted Book Value
Business Valuation
       Capitalization 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:



Business Valuation

 Determining a reasonable figure for business income is key.
 Sometimes referred to as Owner’s Discretionary Income.
Business Valuation
Business Valuation
      Capitalization of Earnings

    Capitalization Rate – Business Type / Perceived 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               10%              10
assets and excellent
Well- established business
requiring considerable             12.5%              8
managerial care

Strong, well developed
businesses susceptible to
general economic swings             15%               7
and requiring considerable
managerial care

Highly competitive
businesses with low levels
of hard assets requiring            20%               5
average levels of
managerial care
Business Valuation

         Category               Capitalization Rate   Multiple
Small, highly competitive
businesses requiring little            25%               4
capital investment

Large or small businesses
requiring special
managerial skills of one or
more persons with little               50%               2
capital investment and in
highly competitive fields
where failure is a strong

Personal service
businesses whose                      100%               1
success reflects the skill of
the manager
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


        Earnings 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         6 – 10%
earnings, predictable future

#2 – Same as #1 except in more                 11 – 15%
competitive industries
#3 – Companies in highly competitive
industries, with little capital investment     16 – 20%
and no management depth, although with
good historical earnings record

#4 – Small businesses that depend on
the skill of one or two people, or large
companies in highly cyclical industries        21 – 15%
with very low predictability

#5 – Small personal service businesses
with a single owner/manager                    26 – 30%
Business Valuation

     Year            Cash Flow    Discount Factor   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
Business Valuation
       Valuing Professional Practices
Business Valuation
       Valuing 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 Valuation

Goodwill can be divided into two forms:
Business Valuation
       Factors Affecting Value

           *Financial Valuation: Applications and Models, James Hitchner
Business Valuation
      Cash 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                  3.5 – 5.5

                    $2,000,000                          5+

Historical Perspective

  Favorable factors that supported using a multiple higher in the range
Historical Perspective

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