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598 Making Key Strategic Decisions She also finds that ACME’s customers are retail distributors of its prod- ucts and the company does not have any significant customer concentration. Generally, relationships with customers have been long term. The company currently has numerous products in the adhesives and sealants area. ACME has several trademarks and several products that are well recognized as well as ACME’s name. Victoria determines through her research that the risk of product obsolescence or replacements by new products is a minimal risk to ACME. ACME has conducted research and development activities and the costs range from $250,000 to $500,000 per year over the past five years. Manage- ment does not expect any significant product developments in the near future. Victoria’s financial analysis examines the dividend paying capacity of ACME. Because the company is closely held, special analysis of the compensa- tion paid to family members and perquisites is necessary. Victoria determines that officers’ compensation, shareholder distributions, and perquisites over the past five years have been as follows: Officers’ Compensation, Perquisites, and Shareholder Distributions Year $ Million 2000 $7.7 1999 5.5 1998 8.2 1997 6.3 1996 6.5 Closely held businesses are frequently operated to minimize taxable in- come. Publicly held companies, in contrast, are operated to maximize earnings for the benefit of the shareholders and public markets. A financial analysis of a closely held company should make adjustments so that revenues and expenses are “normalized.” In this particular case, Victoria determines the amount of economic benefits the family members took from the business and compares that with the market compensation for others employed in similar positions. The difference between the two amounts is actually an economic benefit or dividend (profit) flowing to ACME’s owner. Victoria’s analysis strives to iden- tify the actual profitability of the business enterprise even though it is differ- ent from what is reported on the income statement. ACME has approximately 240 employees at its six locations. The three top individuals in management are family members including Bob. Should the company be sold, it is unlikely that the three family members would remain in the business. Summary of Positive and Negative Fundamental Factors As a result of Victoria’s preceding analysis of ACME’s fundamental position, she identifies the following key positive and negative factors for the company. Business Valuation 599 Positive ACME has been in existence for 20 years. ACME has a long-term history of growing sales and profits. ACME owns several trademarks for products that are well known. ACME has diversification in the number of its manufacturing locations. ACME’s industry outlook is moderately positive. The demand for ACME’s products is expected to continue. Negative ACME is highly dependent on the three family members who hold the top management positions. ACME’s products face significant competition and are regionalized. FINANCIAL STATEMENT ANALYSIS An analysis of a company’s historic financial statements is important (unless it is a start-up business), as the past is usually relevant to estimating future busi- ness operations. If a company has had high growth in recent years, that may in- dicate significant growth potential in the future. If past earnings have been volatile, this is an indication of increased financial risk for a buyer of the busi- ness. While an analysis of the financial statements is important, the process does not stop with looking at the company’s past performance. The ultimate goal of the quantitative analysis is estimating the future profitability of the business since that is what a prospective buyer is looking to receive. Future earnings may or may not be similar to the past. Balance Sheet Analysis Victoria prepares Exhibit 18.1 that presents ACME’s historic balance sheets in condensed form for the most recent five years. She finds that total assets grew an average of 15% per year over the five years and a similar amount in the most recent year. The current assets consist primarily of accounts receivable and in- ventory. Fixed assets primarily consist of land, buildings, and improvements, machinery and equipment, factory construction in progress, and transportation equipment. As of the most recent year’s end, ACME’s depreciable fixed assets were depreciated to 69% of their original costs. The most recent year reflects unamortized intangible assets, consisting primarily of goodwill (that had been recorded in accordance with generally accepted accounting principles) in connection with ACME’s acquisition of a manufacturing facility. Current liabilities consist of accounts payable and the amounts due within the next 12 months on promissory notes and obligations under capital leases. ACME is moderately leveraged. During the past five years, ACME’s in- terest bearing debt (both current and noncurrent portions) increased from $6.6 600 EXHIBIT 18.1 ACME Manufacturing Inc.: Summa ry of condensed balance sheets 1996 –2000. ($million) Growth R ates 2000 1999 1998 1997 1996 1996–2000 1999–2000 Assets Current assets $11.69 $11.56 $12.37 $ 9.43 $ 9.17 6.3% 1.1% Fixed assets, net 13.87 10.36 9.37 7.65 6.79 19.5 33.9 Other assets 3.17 3.00 3.25 1.12 0.62 50.4 5.5 Total assets $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3% Liabilities and Equity Current liabilities $11.50 $ 6.41 $ 8.78 $ 4.34 $ 4.94 23.5% 79.4% Long-term liabilities 5.83 7.26 7.78 4.85 4.96 4.1 −19.7 Total liabilities 17.33 13.67 16.56 9.19 9.90 15.0 26.8% Equity 11.39 11.25 8.42 9.01 6.69 14.2 1.3 Total liabilities and equity $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3% Common Size 2000 1999 1998 1997 1996 Assets Current assets 40.7% 46.4% 49.5% 51.8% 55.3% Fixed assets, net 48.3 41.6 37.5 42.0 41.0 Other assets 11.0 12.0 13.0 6.1 3.7 Total assets 100.0% 100.0% 100.0% 100.0% 100.0% Liabilities and Equity Current liabilities 40.1% 25.7% 35.1% 23.9% 29.8% Long-term liabilities 20.3 29.1 31.2 26.6 29.9 Total liabilities 60.3 54.9 66.3 50.5 59.7 Equity 39.7 45.1 33.7 49.5 40.3 Total liabilities and equity 100.0% 100.0% 100.0% 100.0% 100.0% Business Valuation 601 million to $10.4 million. Debt consists of real estate mortgage notes, term loans, a revolving line of credit, and obligations under capital leases. Over the past five years, the shareholder equity increased from $6.7 mil- lion to $11.4 million. Shareholder equity decreased slightly as a percentage of total liabilities and equity over the past five years. Income Statement Analysis Victoria also prepares Exhibit 18.2 that presents ACME’s historic income statements in condensed form for the past five years. She also prepares Exhibit 18.3, which is a graph of ACME’s annual revenues for the previous five years. It graphically shows the revenue amounts from Exhibit 18.2 and more clearly shows the revenue growth trend. The company had a compounded annual growth rate in revenues of 11.1% during the previous five years and 3.5% for the most recent year. ACME’s revenue growth rate over the past five years was substantially higher than the 5.6% revenue growth reported by the chemical products industry. Cost of goods sold as a percentage of revenues fluctuated between 66.6% and 69.9% over the past five years. Operating expenses, exclusive of officers’ compensation, ranged from 9.8% to 11.8%. The overall trend is up. ACME reported consistent profitability during the past five years. In 1996, income before officers’ compensation and taxes was $6.5 million ($4.31 + $2.23). For 2000, it increased to $8.7 million ($5.29 + $3.38). Ratio Analysis Victoria also prepares Exhibit 18.4 that presents various financial operating ratios of ACME for the past five years. The liquidity ratios indicate the ability of ACME to meet current obligations as they come due. The current ratio decreased from 1.9 to 1.0 during the five-year period. Working capital also de- creased from $4.2 million to $190,000 during the same five-year period. These indicate the company has a greater risk in being able to pay its bills. The activity ratios indicate how effectively a company is utilizing its as- sets. The average number of days in ACME’s accounts receivable was similar over the past five years at approximately 50 days. However, the average num- ber of days inventory remained at the plant before being sold decreased from 58 days to 47 days. The average number of days of accounts payable was simi- lar during the five-year period at 48 days. The coverage ratios indicate a company’s ability to pay debt service. The number of times interest was earned, as measured by earnings before interest and taxes (EBIT) divided by interest expense, decreased from 8 to 7 times. The leverage ratios generally indicate a company’s vulnerability to busi- ness downturns. Highly leverage firms are more vulnerable to business down- turns than those with lower debt-to-worth positions. ACME’s debt to tangible worth increased in the past five years from 1.5 to 1.8. Fixed assets to tangible worth increased from 1.0 to 1.5. 602 EXHIBIT 18.2 ACME Manufacturing Inc.: Summa ry of condensed income statements 1996 –2000. ($million) Growth R ates 2000 1999 1998 1997 1996 1996–2000 1999–2000 Revenues $50.29 $48.59 $40.85 $37.94 $33.02 11.1% 3.5% Cost of goods sold 34.80 33.95 28.45 25.25 22.63 11.4 2.5 Gross profit 15.49 14.64 12.39 12.69 10.39 10.5 5.7 Operating expenses 5.95 5.58 4.34 3.72 3.31 15.8 6.7 Officers’ compensation 3.38 2.86 3.53 3.03 2.23 11.1 18.4 Operating EBITDA 6.15 6.20 4.52 5.94 4.86 6.0 −0.9 Depreciation and amortization 0.31 0.22 0.10 0.05 0.07 44.9 42.3 Operating income (EBIT) 5.84 5.99 4.42 5.89 4.79 5.1 −2.5 Miscellaneous (income) (0.30) (0.25) (0.19) (0.18) (0.12) 26.1 17.1 Interest expense 0.84 0.74 0.55 0.47 0.59 9.0 12.6 Pretax income 5.29 5.49 4.06 5.60 4.31 5.3 −3.6 Less: Income taxes* — — — — — N/A N/A Net income $ 5.29 $ 5.49 $ 4.06 $ 5.60 $ 4.31 5.3% −3.6% Common Size 2000 1999 1998 1997 1996 Revenues 100.0% 100.0% 100.0% 100.0% 100.0% Cost of goods sold 69.2 69.9 69.6 66.6 68.5 Gross profit 30.8 30.1 30.3 33.4 31.5 Operating expenses 11.8 11.5 10.6 9.8 10.0 Officers’ compensation 6.7 5.9 8.6 8.0 6.8 Operating EBITDA 12.2 12.8 11.1 15.7 14.7 Depreciation and amortization 0.6 0.5 0.2 0.1 0.2 Operating income (EBIT) 11.6 12.3 10.8 15.5 14.5 Miscellaneous (income) −0.6 −0.5 −0.5 −0.5 −0.4 Interest expense 1.7 1.5 1.3 1.2 1.8 Pretax income 10.5 11.3 9.9 14.8 13.1 Less: Income taxes* 0.0 0.0 0.0 0.0 0.0 Net income 10.5% 11.3% 9.9% 14.8% 13.1% * ACME is an S corporation for tax purposes and taxab le income is passed through to the shareholder. Thus, the co rporation does not pay income taxes. Business Valuation 603 The profitability ratios reflect the returns earned by ACME and assist in evaluating management performance. ACME has been consistently profitable in each of the past five years. The earnings before taxes to tangible worth fluc- tuated between 55% and 66%. Officers’ compensation ranged from $2.2 mil- lion to $3.6 million during the five years and was $3.4 million in the most recent year. EXHIBIT 18.3 ACME Manufacturing Inc.: Revenue growth 1996 –2000. Year Dollars (millions) Revenues 1996 1997 1998 1999 2000 $- 10 20 30 40 50 60 EXHIBIT 18.4 ACME Manufacturing Inc.: Ratio analysis 1996 –2000. 2000 1999 1998 1997 1996 Liquidity ratios: Current ratio 1.0 1.8 1.4 2.2 1.9 Quick ratio 0.6 1.1 0.9 1.3 1.1 Activity ratios: Revenue/accounts receivable 7.3 7.5 7.0 7.8 7.2 Days’ receivable 49.8 48.6 52.4 46.9 50.4 COS/inventory 7.8 7.6 6.4 7.2 6.3 Days’ inventory 46.6 47.8 57.2 50.5 58.1 COS/payables 7.6 9.4 4.9 7.4 7.6 Days’ payables 47.7 39.0 73.9 49.2 48.0 Revenue/working capital 274.2 9.4 11.4 7.5 7.8 Coverage/leverage ratios: EBIT/interest 7.3 8.4 8.4 13.0 8.3 Fixed assets/tangible worth 1.5 1.1 1.5 0.9 1.0 Debt/tangible worth 1.8 1.5 2.6 1.0 1.5 Profitability & operating ratios: EBT/tangible worth 55.4% 58.8% 63.4% 62.8% 65.5% EBT/total assets 18.4% 22.1% 16.2% 30.8% 26.0% Revenue/fixed assets 3.6 4.7 4.4 5.0 4.9 Revenue/total assets 1.8 2.0 1.6 2.1 2.0 604 Making Key Strategic Decisions COMPARISON TO INDUSTRY AVERAGES Victoria also compares ACME’s key financial ratios to peer companies. The main differences between ACME and other companies of similar size in the same industry are as follows: • ACME’s liquidity is significantly less than other companies in the group. Similar companies had a ratio of 1.6 while ACME had a current ratio of 1.0. This is likely due to ACME having a significant portion of its financ- ing due within twelve months as opposed to longer term financing. • The average number of days in accounts payable for ACME is 48 days and is significantly more than the peer group at 32 days. This is likely due to the company taking longer to pay its expenses related to raw materials and inventory than that of its peer group because of low working capital. • The times interest earned measure for ACME is significantly higher than its peer group. The company had a measure of 7.3 as compared to its peers at 4.0. This is likely due to ACME having a higher profit margin than its peers. • ACME is significantly more leveraged than its peer group. Its measure of debt to tangible worth is 1.8 as compared to its peers at 1.2. Also, the company’s measure of fixed assets to tangible worth is 1.5 as compared to its peers at 0.5. This assessment is related to the company having a higher level of fixed assets as compared to its tangible worth. • ACME is more profitable than its peers. The measure of earnings before taxes to total assets was 18%, as compared to its peers’ 12%. Additionally, ACME’s earnings before taxes to tangible worth was 55% as compared to its peers at 22%. This is due to ACME’s profit margin of 11%, as com- pared to its peers at 5%. The purpose of the this part of Victoria’s analysis is to assess the risk fac- tors of owning this business as compared to an investment in the average peer company. As previously discussed in this chapter, investors have options of where to place their capital and rational investors require a higher reward (in the form of returns) for investments with higher risks. APPR AISAL OF FAIR MARKET VALUE Victoria tells Bob that the shares of ACME are closely held securities and there is no ready market for their sale. The three general approaches available for the valuation of private business interests were discussed earlier in this chapter. Victoria considers all relevant valuation approaches and methods and ulti- mately relies on two approaches to estimate the value of ACME’s common stock—a market approach and an income approach. She rejects the asset ap- proach because the premise of value is a going concern and the company has no Business Valuation 605 intention to liquidate the assets. In addition, this approach does not clearly re- flect the value of the business resulting from its earnings potential. Debt-Free Analysis She further explains to Bob that there are two ways to value the equity (stock) of a private business under the income approach. The first is the direct equity methodology. Under this approach a company’s net income or cash flow is the basis to determine the value of the company’s stock. This methodology either capitalizes net income or net cash flow, or it determines the present value of a series of future cash flows. The second is the debt-free methodology (or invested capital methodol- ogy). How much or how little a company is leveraged can have a significant im- pact on the value of the company’s stock. If a specific company has too little leverage or too much leverage as compared to an ideal blend of debt and equity capital, the direct equity methodology may result in a distorted valuation. A company’s invested capital represents all of its sources of capital to fund the business—capital from investors (equity) and lenders (debt). When we say the value of a “business,” it often has a different meaning from the value of the corporation’s equity. This concept is illustrated below. When we say the value of a “business” or “company,” we are often refer- ring to the value of the overall capital (the debt and equity capital equals the total assets). Many sales transactions are structured only to transfer the assets of a business and it is up to the buyer to raise capital from investors and/or lenders. (In an asset sale, the seller would be responsible for paying off the ex- isting debt, usually upon the receipt of the sales proceeds.) When the objective is to value only the equity, debt is subtracted from the value of the total assets. This is the underlying model of the debt-free methodology. First, the total as- sets are valued based on the company’s cash flow without regard to servicing the debt. Second, if the equity is being valued, then the company’s debt is sub- tracted from the value of the assets. The direct equity methodology determines the value of the equity by using the net cash flow after the company services its debt, which results in a = Value of assets Value of overall capital structure Debt Equity 606 Making Key Strategic Decisions lower cash flow. Then a discount rate or capitalization rate (multiple) is ap- plied. The result is the value of the company’s equity. The direct equity and debt-free methodologies are summarized below: COST OF CAPITAL Bob asks Victoria to explain the cost of capital. She says that when a business owner or prospective buyer is raising capital, debt capital is less expensive than equity capital. Debt capital represents those monies borrowed from a lender, such as a bank, to fund the business. The lender expects a return on its invest- ment in the form of interest. From a financial prospective, interest expense on the debt is called the cost of debt. Therefore, the business pays interest, or the cost of debt, which is often near the prime lending rate. ACME’s cost of debt that it pays in interest is 9%. However, since ACME can take a tax deduction for the interest expense, its actual cost of debt capital is 5.4% (9% interest cost less 40% in reduced taxes). For every $100 ACME pays in interest expense to the bank, its income tax obligation is lowered by $40 because interest is a busi- ness expense that lowers taxable income. Thus, ACME’s after-tax interest ex- pense is $60 ($100 minus $40 in reduced taxes). In order for a business to raise equity capital (selling stock to investors), it expects to provide the shareholders a rate of return. As previously discussed, stocks of large public companies have had average returns of 10% to 12% per year to the shareholders over an extended time period. Small public company stocks have traditionally yielded 15% to 20% to shareholders. Since closely held companies are frequently more risky than small public companies, most private businesses must offer a rate of return to shareholders exceeding the returns of small public stocks. Let’s say that a closely held business is raising capital by selling stock. The return a company expects to give its investors (stockholders) in order to attract their capital is called the company’s cost of equity. Therefore, a company has a cost of debt capital and a cost of equity capital. Combined, they are referred to as a company’s cost of capital. The cost of debt is less than the cost of equity as illustrated above. Management of a busi ness can Direct Equity Methodology Debt-Free Methodology Net income or net cash flow to equity holders (defined later) Net cash flow to holders of total in- vested capital (defined later) Apply discount rate or capitalization rate on a cost of equity basis (dis- cussed later) Apply discount rate or capitalization rate on a weighted average cost of capital basis (discussed later) Results in value of company’s equity Results in value of company’s invested capital (debt and equity) Subtract value of debt capital to arrive at the value of the company’s equity Business Valuation 607 maximize the shareholders’ returns by using a blend of debt financing (less ex- pensive) and equity capital (more expensive). Say that a prospective buyer of a business must raise $10 million to acquire the company. If it raised the entire $10 million from the sale of stock, it would have to pay those shareholders a rate of re- turn of, say, 20%. Or, it could raise a portion of the $10 million by borrowing from a bank at, say, an after-tax interest cost of 5%. Obviously, the cost of debt is significantly less than the cost of equity. If management borrows $5 million from the bank and raises another $5 million through the sale of stock, its overall cost of capital is significantly lower than if the company raised the entire $10 million from the sale of stock. This comparison is presented below: Blended Capital Structure of Debt and Equity Weighted Average Type of Amount Cost of Cost of Capital ($ million) Percent Capital Capital Debt $ 5 50% 5% (after-tax) 2.5% Equity 5 50 20 10.0 Debt and Equity 10 100 N/A 12.5 No Debt in Capital Structure Type of Amount Cost of Capital ($ million) Percent Capital Equity $10 100% 20% The above illustrates that with the proper blending of debt and equity capital, management can decrease its overall cost of capital from 20% to 12.5%. This has the effect of increasing the shareholders’ rate of return. It also has a positive effect on the value of the company’s stock. (This concept of different returns for different types of capital and the respective weightings is called the band of investment methodology when used in real estate appraisals.) The relevance of all this to business valuation is that if a particular com- pany does not already have the proper blend of debt and equity capital, a valuation may be performed and have an incorrect result unless a more sophis- ticated debt-free analysis is done. The direct equity methodology does not take into account an optimal blend of debt and equity (unless the business al- ready happens to have it). Consequently, the result of a valuation using the di- rect equity methodology may result in an incorrect value. However, if the business already has an appropriate blend of capital, the direct equity method is a simpler valuation methodology and produces a correct value result. In ad- dition, buyers of smaller private companies do not necessarily take capital structure into account when making purchase decisions, so a debt-free analysis may not be necessary for these companies to determine fair market value. Victoria’s research indicates that ACME does not have the ideal capital structure. Therefore, she concludes that a debt-free methodology is neces sary to . should make adjustments so that revenues and expenses are “normalized.” In this particular case, Victoria determines the amount of economic benefits the family. net 13.87 10.36 9.37 7.65 6.79 19.5 33.9 Other assets 3.17 3.00 3.25 1.12 0 .62 50.4 5.5 Total assets $28.72 $24.92 $24.98 $18.20 $16.58 14.7% 15.3% Liabilities