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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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

Tax Court’s Adjustment to Reasonable Compensation ‘Dizzying and Arbitrary’

Menard v. Commissioner, 2009 WL 595587 (C. A. 7)(March 10, 2009)

The CEO of The Home Depot was paid $2.8 million in salary in 1998. The CEO of Lowe’s received $6.1 million (neither including bonus). Yet when the CEO of the nation’s third largest retail home improvement chain, Menards, posted roughly $20.6 million in salary (including bonus), the IRS stepped in and disallowed $19 million as a corporate deduction.

The reason: The IRS claimed that it was a disguised dividend.

The Tax Court applied a unique formula.

The CEO, John Menard, founded the Wisconsin-based Menards hardware stores in 1962. He worked six or  seven days a week, up to 16 hours a day, and was involved in every detail of company operations. Under his management, revenues grew from $788 million in 1991 to $3.4 billion in 1998. The company’s return on shareholder equity in 1998 was 18.8%. By contrast, Home Depot returned a 16.1% return on investment that year, and Lowe’s rate of return was lower.

Menard owned all the voting shares in the company and 56% of the non-voting shares. He was paid a  modest base salary and a portion of a profit-sharing plan; in 1998, he earned $157,500 and $3 million from these sources. A bonus program, adopted by the board of directors in 1973, for his “commanding” management role, awarded him an additional 5% of company earnings (before taxes) at the end of each year. In 1998, the 5% bonus yielded the CEO an additional $17.5 million, conditioned on the IRS allowing its deduction from corporate income.

At trial the IRS not only persuaded the Tax Court that the bulk of the CEO’s compensation was excessive, but that because it was conditional and paid at year’s-end, it was also intended as a dividend, especially since the company didn’t pay formal dividends to other shareholders.

As to the “excess”, the Tax Court found that any compensation above $7.1 million for Menard was too much. The court used its own unique formula to arrive at this conclusion:

  1. Divide Home Depot’s return on investment (16.1%) by its CEO’s salary ($2.84 million);
  2. Divide Menard’s return on investment (18.8%) by the result of step (1); and then
  3. Multiply the result ($3.32 million) by 2.13, or the ratio of the compensation of Lowe’s CEO to that of Home Depot’s CEO.

The appellate court considered the Tax Court’s formula an arbitrary and dizzying adjustment. It disregarded differences in the full compensation packages of the three executives being compared (the Home Depot CEO made more than $124 million
from 1998-2004) , differences in whatever challenges faced the companies in 1998, and differences in [their] responsibilities and performances (Menard was by far the most active, hard-working).

Not a concealed dividend.

The Tax Court ignored the substantial level of risk in Menard’s compensation structure, given its direct tie to company earnings. Not to mention the fact that the 5% bonus program had been in place for 25 years before the IRS “pounced,” the court said. It did not look like a dividend, because corporate dividends are generally tied to specific dollar amounts and do not serve the same incentive purpose to the passive shareholder.

The Seventh Circuit reversed the Tax Court’s decision.