The ability to make sense of financial statements and to have a coherent view of a business’ financial health or to estimate the value of private businesses is an essential skill that any underwriter should possess and sharpen. This is particularly true if they work in a high net worth unit or if the value of the business interests make up most of a prospective insured’s net worth.
Furthermore, it is important from a sound financial underwriting standpoint to verify that the corporate finances are healthy and that the estimated market value of the business is reasonable. Knowing what the vital figures mean will definitely improve the underwriter’s professional judgment.
What are Financial Statements?
Financial statements give the reader an overview of the financial activity of a corporation between two sets of dates. They tell the accumulated financial story of a business at the end of the accounting period and how the business owner’s idea has translated into financial success or despair. There are five basic and fairly standardized parts to North-American financial statements.
The auditor's report provides the degree of accounting review of the financial statements. All the company’s stakeholders (shareholders, tax authorities, banks, regulators, suppliers) have a vested interest in ensuring that the financial statements are accurate and without material misrepresentation. There are three levels of review:
- No assurance is the basic compilation of data and is the most common level for small and medium sized private corporations
- Reasonable assurance indicates a partial audit
- Full review is the most stringent level of auditing for public companies.
The final auditor’s opinion is usually one of the following:
- An unqualified opinion means a clean audit
- A qualified opinion means that minor accounting issues have been identified
- An adverse opinion indicates the presence of material misrepresentation and that the statements don’t conform to the country’s generally accepted accounting principles (GAAP)
The balance sheet reports what the company owns (assets), what the company owes (liabilities) and the shareholders’ equity (the initial owner’s investment plus the retained profits or deficit). In the double-entry accounting system, the basic accounting equation defines that the total assets must equal the total liabilities plus the owners’ equity.
Assets are further subdivided into the current assets (cash and marketable securities, accounts or trade receivables, and inventory or work in progress) and the fixed assets (land, building, machineries and other equipment). Liabilities are subdivided into the current obligations (short-term indebtedness, accounts payable to suppliers, taxes due) and the long-term liabilities, representing all the debts that are due in excess of one year.
The income statement tells how much the company earned during the accounting period. The gross revenue represents the proceeds received from the sale of products and services from which the operational, administrative, financial expenses and taxes are deducted. The net result for the period will increase (profit) or decrease (loss) the retained earnings account in the balance sheet.
The statement of cash flows records how cash flows in and out of the business by taking into account all the monetary transactions. The resulting “net cash change” at the end of the accounting period increases or decreases the amount held in the cash accounts (short-term assets) or bank indebtedness (short-term obligations) in the balance sheet.
There are three sources of cash flow:
- The cash flow from operating activities represents the cash generated by the corporation’s normal operations from its sales of products or services. High growth businesses tend to initially have a negative operating cash flow. However, the trend for all businesses should be upward.
- The cash flow from investing activities involves capital expenditures and acquisitions of property, plant or equipment. Typically, a company will reinvest into its own business by at least the rate of its depreciation and amortization expenses. If a business does not reinvest, it may show artificially higher cash flows to the detriment of its long-term financial health.
- The cash flow from financing activities indicates the sources of cash flowing in and out of the business by raising additional capital (cash inflow) or buying back the company’s own stocks (cash outflow), new borrowings from lending institutions (cash inflow) or reimburse loans (cash outflow).
Though the cash flow statement can be challenging to review because of its inherent complexity, the flow of cash is deemed to be one of most vital and key components of the company’s business cycle. It is considered by many financial analysts as being one of the single most powerful sources of information for analyzing the financial health of a business, because if cash dries out, the business can become insolvent.
The notes to the financial statements provide detailed disclosures and forward-looking statements to key items of the balance sheet and the income statement. Since they are an integral part of the financial statements and can influence the entire interpretation, missing notes could be considered as a warning sign.
Financial analysis is the process of reviewing and evaluating a corporation’s financial statements, thereby gaining an understanding of the financial health of the company from an external reader’s perspective. The purpose of a ratio analysis is to put financial data into a form that allows for the measurement and comparison of the company’s performance to previous years or industry peers.
Financial ratios taken in isolation may be misleading. They cannot be regarded as absolute predictors of the future financial fortune of a business but, rather, give the analysts some indication of the financial strengths and weaknesses of the studied company. To be meaningful, the ratios must be compared to historical values, and it is the trend that is mostly significant. Some internal factors (choice of accounting methods) or external factors (seasonal influences) may distort the end-of-year values.
From an underwriting perspective, one should keep in mind that for professional partnerships, sole proprietorship or family businesses, the ultimate business goal may not be the maximization of the shareholder’s value as seen in larger private or public companies. The goal may be to provide the business partners with a more than adequate income for themselves. Therefore, financial ratios may not be as indicative of the true financial health for these types of businesses.
Liquidity ratios are used to determine a company's ability to pay off its short-terms obligations. Lenders and bankruptcy analysts frequently use the liquidity ratios to determine whether a company will be able to continue as a going-concern. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term obligations.
working capital ratio represents the financial margin if the company would pay all its current obligations from its current assets. It is indicative of the ability for the corporation to carry on its normal business comfortably and without financial pressure or to meet financial emergencies without having to raise additional capital or increasing its indebtedness. A ratio below 1 indicates a certain degree of financial duress while a ratio over 2 means that the company is hoarding excess cash ineffectively. Most financial analysts believe that a ratio between 1.2 and 2.0 gives a comfortable margin.
cash ratio, also known as the acid test, is a more stringent and realistic test of the business’ ability to repay its immediate obligations than the working capital ratio. It only uses the most liquid assets (cash and marketable securities) by excluding inventory and prepaid items which cannot easily be turned into immediate cash. Generally, a ratio of 1:1 or better is considered an adequate ratio.
Leverage ratios can be used to determine the overall level of solvency that a company and its shareholders face. In general, the greater the relative amount of debt held by a company, the greater the assumed financial risk. In the normal course of operations, shareholders may benefit from financial leverage to the extent that the operating return realized from the use of borrowed funds exceeds the interest paid on the funds. While greater financial leverage increases the opportunities for enhanced cash flow, it also increases the risk of default and bankruptcy.
- The debt-to-assets ratio measures the extent to which the acquisition of assets has been financed by debt. The more debt compared to the assets a company has, the more leveraged it is and the riskier it is considered to be. In theory, larger, well-established, typically public companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.
- The debt-to-equity ratio indicates the amount of liabilities the business has for every dollar of shareholders' equity and measures the management's reliance on debt financing compared to the amount invested by its shareholders. If this ratio is too high, the company is said to be highly leveraged, i.e. “more risky” from a financial standpoint.
Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return. Higher values are indicative that the company is performing well and can sustain its future growth.
Return on Assets (ROA) is an indicator about how efficiently earnings are generated by the invested capital (assets). A low ratio may indicate an inefficient use of the employed assets. Moreover, a business with a relatively low ROA will usually not be unable to generate a satisfactory return on equity (ROE). A higher ROA indicates that the business assets are being employed efficiently and creating value for its shareholders.
Return on Equity (ROE) measures the ultimate rate of return the shareholders receive on their investment in the business and should be compared to the rates for treasury bonds to assess its financial risk exposure. A favorable ROE shows how well a company uses invested funds to generate earnings and growth. The higher the ratio, the better the return is to the shareholders. However, too high ROE’s, well above the traditional expected 15 to 20%, may be indicative of an underlying speculative business model.
Valuation Approaches for Private Businesses
For the purpose of justifying an adequate insurance amount, specifically for US estate and Canadian capital gain taxation or funding shareholder’s agreements, the value of a company must be estimated, since the book value of a corporation rarely reflects its market value. The difference between the book value and the market value of a going-concern is called the goodwill.
There are many critical factors driving the value of the goodwill and among them are the quality of management and workforce, the brand recognition, the quality of the products or services, the reputation, the customer loyalty and ability to repeat business, the company’s market share and penetration, its intellectual capital, patents and licenses, the ease of its marketability, the future profitability and the perceived future gain in shareholders’ value.
What is a Business Valuation?
While financial statements record the past, business valuation is a forward-looking process for estimating the market value of a business by trying to determine a monetary value to its goodwill. The major challenge for business appraisers (US) and valuators (Canada) is to understand the factors which make a specific company distinctively unique, to estimate what the future earnings or cash flows may be and to apply an appropriate capitalization or discount rate to bring those future benefits to their present or future value.
A professional business valuation is a complex and expensive process that must withstand the scrutiny of legal courts. It is typically obtained in cases of purchase or sell of a closely-held business, estate freezes, estate taxation or gifting purposes, litigation between shareholders, divorce settlements.
Liquidation Value - When a business is considered to be a failing-concern, the liquidation approach may be used to determine the residual value of the business. The liquidation value is the likely price of an asset when it is not allowed sufficient time to be sold on the open market, either in an orderly or forced manner. The liquidation value can be significantly less than the market value, because unlike cash or marketable securities, certain illiquid assets, like real estate or equipment, often require a much longer period of time in order to obtain their market value when sold.
Asset-based Method - This method considers the business total assets rather than its earnings or cash flows, whereby the value of the company rests in adjusting the book value of the underlying amortized fixed (long-term) assets to their market value. Asset-intensive businesses such as manufacturers, real estate development corporations and income-producing holding companies are usually valued under the adjusted book value method whereby the challenge is to find the appropriate adjustment markup.
One simplified method for underwriting purposes would be to use the latest municipal value of real estate properties or plants, and to add back the accumulated amortization to the book value of equipment, so called replacement value.
Farms: The most important assets of agricultural businesses are the market value of their land and their production quota. If the farm land is situated close to the city limits, the current value of the land can be considerable for future real estate development. As well, the underwriter should be aware of the significant short-term financing needs of farms due to their seasonal production activities and overall greater dependency on external factors, like weather, outbreaks of cattle disease, machinery breakdowns.
Property management: The most important factors for property valuation remain "location, location and location" since there are wide macro- and micro-geographic disparities in real estate. Zoning (commercial versus residential) is another critical valuation factor. From an underwriting perspective, accessing aerial maps and street views from the web can take a little of the guessing out of the equation.
Capitalization of Earnings Method
In this approach, the value of the company rests in the capitalization of its (maintainable) earnings rather than adjusting the value of the fixed assets. The capitalization of earnings is ideally done by taking the weighted average of the estimated earnings and multiplying them by a capitalization rate.
Non-asset intensive businesses such as service companies, retailers and distributors with a reasonable predictable operating history where depreciation and amortization of fixed assets are mostly immaterial, are usually valued using this “income” approach. Price-to-Earnings (P/E) ratios are available for publicly traded US corporations in the Industry Center on Yahoo Finance (http://biz.yahoo.com/ic/).
For smaller privately-held businesses, as seen routinely in the underwriting process, a discount for lack of marketability (DLOM) and high reliance on the owner/operator must imperatively be applied to these multiples. The DLOM takes into account that there is no formal open market for small privately-held corporations and buyers can be difficult to find, thus decreasing their intrinsic market value. Discounts for privately-held businesses range typically from minimum 35 to 60%, and even more.
For professional service business, restaurants, hotels, insurance brokerage, real estate agencies, medical, dental or legal practices, accountants, architects, hair salon, garages and similar businesses, the valuation for underwriting purposes can empirically be based on the gross revenue adjusted by a factor between 0.75 and 1.5. The higher ratio can be used when the business produces consistent good earnings, reasonable bonuses are paid out and the owners are building up equity by retaining the profits within the corporation
Discounted Cash Flow Method
Under this approach, the value of the company rests in the discounted value of its forecasted cash flows. The discounted cash flow (DCF) method relies heavily on economic and financial assumptions (pro-forma or “as if” statements) and thus is mostly appropriate for businesses with volatile, cyclical cash flows or without a track record (start-ups) or for ventures with limited lifespan (mining, oil and gas, other natural resources).
In the DCF approach, the discount factor is represented by the weighted average cost of capital. WACC is defined as the minimum return that a company must earn on its existing asset base to satisfy its providers of capital (shareholders and lenders) and is calculated by taking into account the relative weighted returns of each component of the capital structure (debt and equity).
Widely used in the US where there is more market data than in Canada is the market comparable method. It is commonly used by investment brokerage firms on Initial Public Offerings (IPO) and in real estate appraisal, both commercial and residential.
Financial statement analysis and business valuation are both tools of sound financial underwriting. While financial statement analysis looks at the past financial performance, the current liquidity and long-term solvency of a business, its purpose is to identify areas of financial concern.
Conversely, business valuation is forward looking, whereby choosing the appropriate valuation method is key in estimating the fair market value of a business. The market value of public corporations is rather straightforward, since the shares are traded on stock markets, but because of the absence of an open market, estimating the fair market value of private businesses remains a complex and challenging process from an underwriting standpoint.
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Warren Buffet and the interpretation of financial statements
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Business Analysis, Microsoft Excel 2010
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Advanced financial statement analysis
Financial ratio tutorial
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Finance for Non-Financial Managers
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Key management ratios (the 100+ ratios every manager needs to know)