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.

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.