WHEN THE FINANCIAL STATEMENTS have been made as accurate as possible, the buyer or his accountant should analyze the information they contain. Some comparisons and ratios that can be used to bring out trends and relations are discussed in this chapter.

Probably the first analysis to be made is to compare financial statements for the past 10 years or as close to that length of time as possible. Has the trend over the years been up or down, or has there been no significant change? All items on the statements should be studied.

The changes from one year to another will be more helpful if they are stated in percentages. On each year's income statement, the net sales figure is taken as 100 percent and each other item is stated as a percent of net sales. On the balance sheet, total assets are taken as 100 percent and other items are stated as percents of total assets. Such statements are called "common size" statements. Typical comparative statements covering 2 years, with common-size percents, are shown in schedules 1 and 2 below.

Ratios and Other Analyses

Certain ratios and other expressions showing relations between items on the financial statements are also helpful in interpreting the statements. Schedule 3 illustrates several commonly used formulas based on the 1978 figures in schedules 1 (below) and 2. Each of them is discussed briefly following schedules 1, below, 2, and 3.

Schedule 1 Comparative Balance Sheet December 31, 1978 and December 31, 1977

Amount Percent --------------------- --------------

1978 1977 1978 1977 -------- -------- ----- ----- ASSETS

Current assets: Cash..................... $ 28,000 $178,000 2.64 18.43

Marketable securities.... 0 160,000 0 16.56

Accounts receivable (net) 136,000 128,000 12.83 13.25

Notes receivable......... 8,000 3,000 0.76 0.31

Inventories.............. 380,000 368,000 35.86 38.10

Prepaid expenses......... 11,600 12,000 1.09 1.24 -------- -------- ----- -----

Total current assets....... 563,600 849,000 53.18 87.89

Property, plant, and equipment (net)............ 396,200 77,000 37.38 7.97

Intangibles................ 100,000 40,000 9.44 4.14 -------- -------- ------ -----

Total assets...............$1,059,800 $966,000 100.00 100.00 ---------- -------- ------ ------

LIABILITIES AND OWNERS EQUITY

Current liabilities: Accounts payable......... $100,800 $120,000 9.51 12.42

Notes payable............ 0 20,000 0 2.07

Accrued taxes payable.... 1,600 2,400 0.15 0.25

Unearned revenues........ 6,000 0 0.57 0 --------- -------- ------ ------

Total current liabilities.. 108,400 142,400 10.23 14.74

Mortgage payable........... 120,000 20,000 11.32 2.07 --------- -------- ------ ------

Total liabilities.......... 228,400 162,400 21.55 16.81 --------- -------- ------ ------

Owners equity: Original investment...... 500,000 500,000 47.18 51.76

Retained earnings........ 331,400 303,600 31.27 31.43 --------- -------- ------ ------

Total owners equity....... 831,400 803,600 78.45 83.19 --------- -------- ------ ------

Total liabilities and owners equity...........$1,059,800 $966,000 100.00 100.00 ---------- -------- ------ ------

Schedule 2 Comparative Income Statement Years ended December 31, 1977 and 1978

Amount Percent ----------------------- ---------------

1978 1977 1978 1977 ---------- ---------- ------ ------

Gross sales................$1,947,000 $1,706,000 101.41 101.21

Sales returns.............. 27,000 20,400 1.41 1.21 ---------- ---------- ------ ------

Net sales.................. 1,920,000 1,685,600 100.00 100.00

Less cost of goods sold.... 1,430,000 1,245,000 74.48 73.86 ---------- ---------- ------ ------

Gross margin............... 490,000 440,600 25.52 26.14 ---------- ---------- ------ ------

Operating expenses: Wages paid............... 282,800 243,000 14.72 14.41

Taxes.................... 65,000 62,000 3.38 3.68

Insurance................ 48,000 48,000 2.50 2.85

Telephone................ 4,800 4,400 0.25 0.26

Miscellaneous............ 10,800 5,500 0.58 0.33 ---------- --------- ------ ------

Total operating expenses... 411,400 362,900 21.43 21.53 ---------- --------- ------ ------

Net income before taxes.. $78,600 $77,700 4.09 4.61 ---------- --------- ------ ------

Schedule 3

Current ratio

Current assets, $563,600 ----------------------------- = 5.2 to 1. Current liabilities, $108,400

Acid test or "quick ratio"

Cash plus assets near cash, $172,000 ------------------------------------ = 1.6 to 1. Current liabilities, $108,400

Days sales uncollected

Accounts receivable, $136,000 ----------------------------- x 365 = 25.5 Days sales uncollected. Charge sales, $1,947,000

Turnover of merchandise inventory

Cost of goods sold, $1,430,000 --------------------------------------- = 3.82 times, merchandise turnover. Average merchandise inventory, $374,000

Return on owners investment

Net income, $78,600 ---------------------------------- = 0.0987, or 9.78 percent, return on Beginning owners equity, $803,600 investment.

Return on total assets invested

Net income, $78,600 ------------------------ = 0.0742, or 7.42 percent, return on assets Total assets, $1,059,800 invested.

owners percentage equity in business

owners equity, $831,400 ------------------------ = 0.7845, or 78.45 percent. Total assets, $1,059,800

Creditors percentage equity in business

Creditors equity, $228,400 --------------------------- = 0.2155, or 21.55 percent. Total assets, $1,059,800

Current ratio. This ratio compares current assets to current liabilities. In the example shown in schedule 3 above, there is $5.20 in current assets for every $1 of current liabilities.

The current ratio establishes an important relation between the business current debt and its ability to pay the debt. The assumption is that a company should be comfortably able to pay current debts from current assets if necessary. In many businesses, however, especially service businesses, current assets are proportionately smaller because there is little inventory. In these businesses, the relation of current assets to current liabilities may be less important.

Acid test or quick ratio. This ratio points out the relation between the current assets that can be most quickly converted into cash and current liabilities. It is similar to the current ratio except that it uses only assets that are just one step away from being cash.

"One step away from cash" means that only one additional transaction is needed to convert the asset into cash. For example, accounts receivable only have to be collected and marketable securities sold. Merchandise inventories that are normally sold on credit, on the other hand, are two steps away from cash. The inventory will first be sold and accounts receivable created. Then the accounts receivable must be collected before cash is realized from the inventory.

Days sales uncollected. Days sales uncollected shows how fast a business collects its accounts receivable. One way to find this figure is to divide the year-end accounts receivable by the total charge sales for the year and multiply the results by 365.

For this computation to be valid, the accounts receivable must be fairly constant throughout the year. In most businesses, however, sales--and therefore accounts receivable also--tend to be higher at certain times of the year. It is better to use an average if possible.

Turnover of merchandise inventory. The turnover of merchandise inventory is the number of times the average inventory is sold during an accounting period. To find it, divide the cost of goods sold during the period covered by an average merchandise inventory at cost. A high turnover is usually a mark of good merchandising; but if the business only computes its inventory once a year, and that at the low point of the business's cycle, the turnover may appear better than it really is.

Return on owner's investment. The ratio of net income to proprietorship measures the owner's success in making a profit on the money he has invested in the business. Usually, net income after taxes and owner's equity as of the beginning of the year are used. (The beginning figure for any year is the December 31 figure for the year before.) If the owner's equity fluctuated greatly during the period, an average owner's equity should be used.

Return on total assets. This shows the return on the total investment of all who have a stake in the business, creditors as well as the owners.

Owner's percent of equity. For this percent, the year-end owner's equity is divided by the total assets. The share of the assets of a business contributed by the owner is always of interest to anyone trying to analyze the business. Creditors like to see a high proportion of ownership equity--the greater the owner's equity in proportion to that of the creditors, the greater the losses that can be absorbed by the owner before the creditors begin to suffer a loss.

Creditors percent of equity. The ratio of creditor's claims to total assets is always 100 percent minus the owner's percent of equity.

Interpretation of Ratios and Percentages

The value of these ratios and percentages lies mainly in their use as tools of comparison rather than in their absolute values. Thus, a consistent increase or decrease in the current ratios of a business over a 5-year period establishes a pattern that may be significant. Suppose the current ratios for the 5 years are 7 to 1, 5 to 1, 4 to 1, 3 to 1, and 2 to 1.

Clearly, the ability of the business to meet its current debt is declining.

Another important use of ratios is to compare the company's performance with that of similar businesses. For almost every size and type of business, there are published ratios of expenses to sales that are accepted throughout the industry. A comparison between the ratios of the business offered for sale and averages for the trade will bring out any discrepancies. Some of the discrepancies may be due simply to poor management, but each one should be investigated.

Evaluation of Past Years Profits

In using a net-profit figure for past years to project the future earning potential of the business, the buyer or seller should exclude the profit of any year that is unusually high or low because of exceptional circumstances. It may also be wise to use a weighted average for the past Years profits.

Assume, for example, that two similar businesses are to be compared. Their profits for the past 5 years have been as follows:

Year Company A Company B

1.................................$18,000 $2,000

2................................. 14,000 6,000

3................................. 10,000 10,000

4................................. 6,000 14,000

5................................. 2,000 18,000 ------- ------

Total........................$50,000 $50,000 ------- ------

Average...........................$10,000 $10,000

Both businesses show the same average profits over the 5 years and would therefore, on the basis of a simple average, be valued at the same figure. But while company A has been declining, company B has been growing. Some method is needed that will give more emphasis to the profits of the later years.

A weighted average can have this effect. How much the later profits are emphasized over the earlier years will depend on what multiplier is used, and the choice of multiplier is a matter of personal opinion. Here is an example of how a weighted average could be used to give effect to trends in comparing companies A and B:

Year Company A Company B

1..............$18,000 X 1 = $18,000 $2,000 X 1 = $2,000

2.............. 14,000 X 2 = 28,000 6,000 X 2 = 12,000

3.............. 10,000 X 3 = 30,000 10,000 X 3 = 30,000

4.............. 6,000 X 4 = 24,000 14,000 X 4 = 56,000

5.............. 2,000 X 5 = 10,000 18,000 X 5 = 90,000 -- -------- -- --------

Total........ 15 $110,000 15 $190,000 -- -------- -- --------

Weighted av.....$110,000 div. by 15 = $7,334 $190,000 div. by 15 = $12,667

In assessing the future of the business, the buyer must take into consideration any changes he plans to make in the basic financial structure of the business, such as putting in additional capital or not buying all the assets. However, he should not pay for future profits he is going to earn by reason of his own special skills or additional investment. In determining the future income he is purchasing, therefore, he must rely largely on past results of the business operation.

Effect of Changes in Price Levels

When the buyer is analyzing several Years financial statements, he must keep in mind the effect on the statements of changes in price levels; that is, in the purchasing power of money. He should consider the possibility of converting the amounts on the financial statements to a base year.

Putting a Value on Goodwill

Goodwill, when it exists, is a valuable asset. It may result from a good reputation, a convenient location, efficient and courteous treatment of customers, or other causes. However, because it is intangible and difficult to measure, goodwill is sometimes recorded when it does not exist.

From the accountants standpoint, goodwill should be recorded only when it is purchased. It should not be recorded otherwise, they believe, because of the difficulty of placing a fair value on it.

As a practical matter, above-average earnings are normally considered the best evidence of the existence of goodwill, and the value placed on the goodwill at the time of its sale is often determined by capitalizing these extra earnings. Take, for example, a business in a field in which the normal return on investment is 10 percent. Suppose the business has a capital investment of $200,000 and an annual return of about $24,000. The average return on $200,000 for this type of business would be $20,000 a year. Therefore, the business has above-average earnings of $4,000 yearly.

Capitalizing these above-average earnings at 10 percent ($4,000 div. by .10) gives $40,000 as the investment needed to earn the $4,000. Therefore $40,000 may be taken as the value of the goodwill of this firm.

Many people feel that unless a business has above-average earnings, it does not have goodwill. Thus, a business might appear to have an excellent location, enlightened customer policies, and a superb product; yet this business will not have goodwill attaching to it unless its earnings exceed the normal earnings for that type of business.

The measurement of goodwill has many pitfalls. To begin with, a decision must be made as to what normal earnings are. (Industry averages will probably be available, but average earnings for the industry aren't necessarily normal earnings.) And once this decision has been made, the percent at which the above-normal earnings will be capitalized must be decided. In the example given, 10 percent was used. This means that the buyer should recover his investment in 10 years. If he wants to recover his investment more quickly, he will want to use a higher percent, which will give a lower capitalized value. If he is willing to wait longer, he will accept a lower percent, which will raise the capitalized value.

Goodwill is simply a bookkeeping device to represent the value of one part of a business when that business is valued as a whole. In most cases, the total value of the business is decided without a detailed calculation of the goodwill figure--in many cases, without even detailed consideration of the value of the other assets.

Checklist

1. Get financial statements for the past 10 years or as long as the business has been in operation. 2. Make whatever revaluations of the financial statements are necessary to make the statements realistic. 3. Prepare ratios and percentages as needed. 4. Compare results of the company's operations from year to year in the past and with results in the industry at large.

Questions To Be Considered by the Buyer

1. What will happen to the profit when I take over the business? 2. How good is the accounting system that has been used? 3. How good is the cost system? 4. How realistic are the budgets? 5. How much owner's personal expense has been charged to or absorbed by the business? 6. Is there an equipment record--for insurance and to tell me what it costs to maintain various types of machinery? 7. Is the insurance adequate? 8. What have the financing arrangements been, particularly if sources other than a bank were used? 9. What is the rate of return on capital invested and what rate of return do I want for my capital investment?

Part 5 Analyzing the Market Position of the Company

The Market

Introduction: Market Analysis

EVERY BUYER, and indeed every seller, should have some measurement of what the future will offer. This includes not only the possibility of maintaining the same volume of sales as in the past, but also the opportunity to increase sales.

The buyer must have some idea of what he is acquiring besides the physical assets of the business. He is, in fact, investing in or obligating himself to the continued operation of the business. The true value to him lies in the ability of the business to generate sales at lease equal to its current position in the market. This calls for a careful investigation and analysis of two factors: (1) the past growth of the company within the market of which it is a part, and (2) a forecast of the future sales pattern.

The seller also needs a market analysis for the business he proposes to sell. He wants the best possible price for the business--and the better the outlook, the more likely the buyer is to agree to the asking price.

Who Does the Work?

Will a single market analysis fill the needs of both buyer and seller? Separate studies are probably better. The seller has access to data about the business that are not available to the buyer. Unless the buyer has had wide and recent experience in the same kind of business, he may--rightly or wrongly--tend to rely on the seller's statement of the market position of the company.

No two studies of the same company will produce exactly the same results. The buyer's analysis is almost certain to be on the conservative side, and a compromise will be necessary.

Another question is whether the buyer and seller should conduct their own market studies or hire specialists to do it. The detailed and complex type of investigation conducted by a professional market analyst is valuable, of course, but the cost is considerable.

The basic purpose of a market analysis in the buy-sell situation is to get a clearer picture of the company in the marketing scheme and some indication of the general direction in which it is moving. The buyer and seller should be able to gather and analyze the basic data they need for this purpose--if they avoid a highly statistical approach.

Organizing the Study

Part 5 includes five series of questions and a checklist to guide the buyer or seller in his analysis of the market position of the business.

Sample rating charts +-------------------------------------------------------------------+

ÝCOMPANY SALES: Ý Ý Dollar Percent Ý Ý

Year sales change Ý Ý Ý Ý1974.................................. $__________ ___________ Ý Ý1975.................................. ___________ ___________ Ý

Ý1976.................................. ___________ ___________ Ý

Ý1977.................................. ___________ ___________ Ý

Ý1978.................................. ___________ ___________ Ý

ÝDollar increase 1978 over 1974........ $__________ ___________ Ý

ÝPercent increase 1978 over 1974.................... ___________ Ý

ÝHow satisfactory? 1 2 3 4 5 Ý Ý Ý

ÝSHARE OF MARKET: Ý

Ý Share of Ý Ý Industry Company market Ý Ý Year sales sales (percent) Ý Ý Ý

Ý1974................ $____________ $______________ ___________ Ý

Ý1975................ _____________ _______________ ___________ Ý

Ý1976................ _____________ _______________ ___________ Ý

Ý1977................ _____________ _______________ ___________ Ý

Ý1978................ _____________ _______________ ___________ Ý

ÝChange in share of market 1978 over 1974............ ____________Ý

ÝHow satisfactory? 1 2 3 4 5 Ý +-------------------------------------------------------------------+

The list of questions is not complete, and not all of those given will be equally useful for all types of businesses. The nature of the business determines what kind of information is needed and in what detail. The questions will, however, call attention to some aspects of the market that might otherwise be overlooked.

Determining how important to the business a specific market characteristic is presents a problem. What is vital to one company may be unimportant to another. And some system should be worked out for rating each characteristic.

A possible method for this is to list the major subject areas in the study, showing their relative importance, and then to rate them according to a uniform system--a rating scale using numbers, for instance, or words such as "high," "medium," "low," and "not significant." An example of how a numbered scale might work in rating the company's sales over time (one of the characteristics most likely to be studied) is shown in the box above.