What is the Financial Health of Your Business?

What is the financial health of your company?

Knowing the financial condition of your business is extremely important. Fortunately, there is an easy, efficient and reliable way to monitor the fiscal health of your company.

It’s called the Z Score.

The Z Score was developed in 1968 by NYU Professor Edward Altman.  Professor Altman originally intended the Z Score to be a predictor of a Company’s inclination for bankruptcy.

The Z Score for privately held companies consists of 5 performance ratios that are combined into a single score.  The five ratios are weighted using the following formula:

Z  Score = .717A +.847B + 3.107C + .420D + .998E

 

Where:

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = Operating Income/Total Assets

D = Book Value of Equity/Total Liabilities

E = Sales/Total Assets

When analyzing the Z Score, the lower the value, the higher the likelihood of bankruptcy.  The following parameters can help in assessing your company’s position:

Below 1.2 indicates a firm headed for bankruptcy

Between 1.2 and 2.9 is a “gray area”

Above 2.9 indicates bankruptcy is unlikely

Caution: While the above parameters are helpful, my experience has been that individual Companies tend to gravitate toward their own  Z Score and changes can be subtle.  Be very mindful of the trend and take action when the trend goes down.

The importance of analyzing the Z Score trend is highlighted in the case of Borders  Bookstores.  Borders Z Score for the 5 years immediately preceding their bankruptcy follow:

Year                                                                    Z Score

2006                                                                       2.81

2007                                                                       2.00

2008                                                                       1.96

2009                                                                       1.86

2010                                                                       1.79

 

Borders went into bankruptcy in 2011 and the steady decline in their Z Score should have been a warning sign.

Every business owner should know their company’s Z score.  It’s easy to compute and  when monitored over time can be an insightful tool in assessing financial risk.

At Stevenson Valuation Group it’s standard practice to compute the Z Score for all client companies.  We’ve developed a template to facilitate the computation and would be happy to share it with you.

It’s FREE, just send us an e-mail.

Sincerely,

Thomas G Stevenson, CPA, CVA

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Private firms linger longer on the selling block

Dear Clients and Colleagues:

It’s taking longer for private companies to sell and this could have an impact on Marketability Discounts.

A newly updated analysis of data from BVR’s Pratt’s Stats reveals that the time needed to market and sell a privately held business is 211 days, up from 200 days in the previous analysis.

The latest annual update of an ongoing study, Marketing Period of Private Sales Transactions, examines a database of 7,928 private company sale transactions from BVR’s Pratt’s Stats database. The population of the transactions occurred from February 1992 through the end of 2011.

The business valuation concept of marketability deals with the liquidity of the ownership interest; that is how quickly and with what certainty an owner can convert an investment to cash. It is appropriate in the valuation of most privately held businesses to discount the total enterprise value for this lack of liquidity in order to arrive at the company’s fair market value.

The uncertainty involved with liquidity is reflected in business valuations by the Discount for Lack of Marketability (DLOM). The DLOM can be substantial, ranging at times from 30% – 40%, and many factors contribute independently to its determination.

At Stevenson Valuation Group we explore and have experience in analyzing the key contributors to Marketability. For more information, please contact us.

If you have any questions about this article, please don’t hesitate to contact me.

Sincerely,

Thomas G Stevenson, CPA, CVA

Building Value is a Process–Part Three

Under the Income Approach to valuation, maximizing value becomes a function of increasing net cash flow , decreasing an investor’s perception of risk or a combination of both.  Last month we discussed various ways to increase net flow and this month we’ll review various ways to reduce investor’s risk.  In valuation terms, investor’s risk is also referred to as an investor’s required rate of return or, capitalization rate, and it is expressed as a percentage.

A key component in determining the value of a going concern is the strength and transferability of the business’ cash flow.  An investor is likely to pay more for a cash flow that’s predictable than one that is subject to various internal and/or external sources of risk. 

The general rule of thumb is “the lower the risk the higher the value.” 

Below is a sample of some of the factors we commonly consider when evaluating the strength and transferability of cash flow.       

·         Company operating history and volatility of cash flow

·         Depth and quality of management

·         Competition and barriers to entry

·         Access to capital resources

·         Reliance on key person(s)

·         Size and geographic diversification

·         Concentration in customer base

·         Market resources in light of competition

·         Purchasing power and other economies of scale

·         Product and market development resources

·         Technological obsolescence

·         Reliance on vendors

·         Distribution system

·         Financial reporting and controls

·         Long term contracts with customers or unique products or

            market niche

·         Patents, copyrights, franchise rights, proprietary products

·         Operating facilities and capital investment needs

·         Industry and economic conditions

Broadly speaking, capitalization rates range from 17% at the low risk end of the spectrum to over 30% at the high end of the spectrum.  

By working with management, Stevenson Valuation Group has, over time, assisted management in increasing value by enhancing the quality of the company’s cash flow.

Building Value is a Process–Part Three

Under the Income Approach to valuation, maximizing value becomes a function of increasing net cash flow , decreasing an investor’s perception of risk or a combination of both.  Last month we discussed various ways to increase net flow and this month we’ll review various ways to reduce investor’s risk.  In valuation terms, investor’s risk is also referred to as an investor’s required rate of return or, capitalization rate, and it is expressed as a percentage.

A key component in determining the value of a going concern is the strength and transferability of the business’ cash flow.  An investor is likely to pay more for a cash flow that’s predictable than one that is subject to various internal and/or external sources of risk. 

The general rule of thumb is “the lower the risk the higher the value.” 

Below is a sample of some of the factors we commonly consider when evaluating the strength and transferability of cash flow.       

·         Company operating history and volatility of cash flow

·         Depth and quality of management

·         Competition and barriers to entry

·         Access to capital resources

·         Reliance on key person(s)

·         Size and geographic diversification

·         Concentration in customer base

·         Market resources in light of competition

·         Purchasing power and other economies of scale

·         Product and market development resources

·         Technological obsolescence

·         Reliance on vendors

·         Distribution system

·         Financial reporting and controls

·         Long term contracts with customers or unique products or

            market niche

·         Patents, copyrights, franchise rights, proprietary products

·         Operating facilities and capital investment needs

·         Industry and economic conditions

Broadly speaking, capitalization rates range from 17% at the low risk end of the spectrum to over 30% at the high end of the spectrum.  

By working with management, Stevenson Valuation Group has, over time, assisted management in increasing value by enhancing the quality of the company’s cash flow.

Part Two: Building Value is a Process–Increase Net Cash Flow

Dear Clients and Colleagues:

Last month, I shared Part One in “Building Value Is a Process.”  We discussed the three principles of valuation and the three general approaches to valuation.  We concluded that for closely held companies, the Income Approach is often the preferred method of valuation.  Under the Income Approach, maximizing value becomes a function of increasing net cash flow, decreasing an investor’s perception of risk or a combination of both. 

This month, in Part Two, we’ll focus on various ways that Stevenson Valuation Group can help you, the business owner, increase net cash flow…

        Net cash flow is usually used as the measurement of owner benefit because it is net cash flow that is actually available to pay dividends. 

        The primary determinant of what a buyer will be willing to pay for a business is the future cash flow that the buyer expects to realize from the business.  In fact, the single most important factor in closing a sale is the buyer’s belief that future net cash flow will continue to grow, thereby, increasing the value of the business.

        To increase cash flow, Stevenson Valuation Group can help you focus your activities on cash management and profit maximizing techniques. Examples of some of those techniques follow: 

·         Create a cash flow forecast. 

            In essence, we’ll work with you to set goals equal to your definition of success and then back up your plans with achievable monetary benchmarks.

·         Collect accounts receivable fast. 

        The goal is for you to be the industry leader in collections. By decreasing your collection period can loosen up a surprising amount of cash.

·         Don’t over invest in inventory.

        We’ll help you analyze the movement of inventory with a focus on removing slow moving, cash consuming items.  And, we’ll  help you calculate the savings of reducing the your           Company’s average inventory days.

·         View disbursements as investments. 

        Having an outside view of expenditures helps identify disbursements not paying dividends. We can be that objective voice.

·         Maximize your gross margin percentage.

        Similar to the point above, cost of sales is an investment that is measured by your gross margin percentage.  Too often businesses accept the gross margin     percentage as an end result rather than managing it for a desired outcome.

·         Take care of your employees. 

        A well designed employee incentive plans improves productivity and cash flow.

·         Minimize taxes. 

        Stevenson Valuation Group will take the time to help you understand your basic tax framework and work with your tax advisor to minimize the tax impact of increasing your profit.

·         Invest in technology.

        If your Company is not using the latest and most efficient technology it is losing ground   in the market place and value is leaking out.

Of course, every business is different and the actual steps to improving the cash flow of your particular Company will be specific to your Company.  What’s outlined above are general ideas and should not be considered an all inclusive list.  Stevenson Valuation Group considers each client a unique opportunity requiring a tailor – made strategy for meeting specific goals. 

Please call me so we can discuss and set in motion a plan for you to maximize value.

Next month we’ll discuss how Stevenson Valuation Group can help you analyze and reduce an investor’s perception of risk and the impact of risk on your Company’s value.

If you have any questions about this blog, please don’t hesitate to contact me.

Sincerely,

Thomas G Stevenson, CPA, CVA

Building Value Is A Process

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Building Value Is a Process

Part One of a three part series.

 Part One

The process of building value in a company starts with a basic understanding of how value is determined.

There are three appraisal principles that constitute the foundation of valuation theory. These principles are (1) the principle of alternatives, (2) the principle of substitution, and (3) the principle of future benefits.

The principle of alternatives states that in any contemplated transaction both buyer and seller have choices and do not necessarily need to enter or proceed with a proposed transaction.

The principle of substitution states that value tends to be determined by the cost of an equally desirable substitute. In other words, if two items are identical, except for price, a willing buyer will gravitate to the item with the lower price. Or, in terms of an investment, if two investments have equal risk an investor will invest in the item that provides the greatest return.

Finally, the principle of future benefits tells us that economic value reflects anticipated future benefits. Basically, there are three reasons that investors will invest in a certain stock: (1) dividends (future cash flows to the investor), (2) capital appreciation (future cash flows to the investor upon sale), or (3) a combination of the two.

Since there is no ready market for closely held stock, an experienced valuator, keeping in mind the three principles above, will analyze and examine a vast array of information before selecting an appropriate valuation method or methods. The valuation method selected will fall within three general approaches:

Asset Approach

Market Approach

Income Approach

 In the asset approach emphasis is placed on the current value of the assets less liabilities. It is typically used for companies with volatile or low earnings, holding companies, companies that will soon be liquidated and capital intensive operations. It does not provide a value for goodwill which must be computed separately if it exists.

The market approach employs the valuation principle of substitution. The substitution theory states that similar assets have similar values. Therefore, by comparing the subject company to other comparable companies a reasonable estimation of value is obtained. The market method is a highly regarded method for valuing a going concern because value is derived directly from the marketplace. However, finding suitable comparable companies is extremely difficult and often time consuming.

For profitable, non-public companies, the Income Approach is often favored. The income approach measures value based on the principle that the value of a business is equal to the present value of the future benefits of ownership. The benefits of ownership are most often expressed in terms of net cash flow. The present value factor is usually referred to as a capitalization or discount rate and is generally considered to be a measurement of investor risk expressed as a percentage.

The income approach employs a simple formula to determine value:

Value = Benefit/Risk

 Therefore, maximizing value is a function of increasing net cash flow, decreasing risk or a combination of both.

Next month, in Part Two of this article, we will discuss ways to increase cash flow and minimize investor risk.
Sincerely,

Thomas G Stevenson, CPA, CVA