Chapter 12- Business Valuation and Financial Statement Analysis

Question 1

What is business valuation or apparisal?

Answer 1

option of the value of an asset or ownership interrest in a bsuiness enterprise.

Question 2

Final valuation assigned to any business interest is actually a derivation of what?

Answer 2

Fair Market Value
“the price at which the property would change hand between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts”

Question 3

What are the 8 general factors to be taken into a consideration in the construction of any business appraisal?

Answer 3

1. nature and hx of the company
2. general economic and industry outlook
3. book value and financial condition of the company
4. earnings capacity of the company
5. dividend-paying capacity of the company
6. value of goodwill or total intangibles
7. size of business interest under consideration
8. market price of comparable public company stocks.

Question 4

When would a professional valuation report be considered useful to business owners and investors?

Answer 4

1. sale or purchase of a business
2. tax-related valuations
3. marital/corporate/partnership dissolution
4. employee stock ownership plans
5. Initial public offerings (IPOs)
6. stockholder disputes
7. establishment of a buy-sell agreement
8. damage cases

Question 5

The content/format of business financial statements comprise what uniform characteristics?

Answer 5

1. income statement
2. balance sheet
3. cash flow statement
   * can differ by industry, company size, organization and activity.

Question 6

What are Financial ratios?

Answer 6

measure the relationship amoung different items in the financial statement.

Question 7

Define liquidity rations

Answer 7

reveal a companys ablity to cover short-term debt and answer the question “ is bankruptcy a possibility’

• ratio is assets/libabilities. Generally a ratio if 2:1, higher ratio is more favourable
• quick ratio is (current assets - inventory)/liabilities.

Question 8

Define Debt ratios

Answer 8

reveal a company’s long-term solvency “is this comapny struggling?”
> ratio is: (total debt/total assets) higher ratio is more risky
> debt to equity ratio is (total debt/total equity). higher ratio is riskier

Question 9

Define profitability ratios

Answer 9

Measures a company’s ability to generate income and answer the question “is company profitable”

• net profit margin is net profit before tax divided by total sales
• return on asset is net income divided by total assets. low ration idivates inefficent use of assets.
• return on equity is (net income/shareholder equity)

Question 10

Traditional valuation methodologies rely on what?

Answer 10

analysis of the existing financial statements of established businesses.
- good when companies have been established for several years.

Question 11

What is the capitalization of earnings method?

Answer 11

based on the concept that the value of a business is its ability to produce profits.
- requires several years of financial data. Average income is then mutipled by a factor representing the return an invester might expect from investing capital in business.

Question 12

Expected investment return (IR) varies for different types of business. What would be the expected IR and Factor for an old, established business in a moderately competitive industry, significant hard assets, stable earnings, experienced and stable management, excellent goodwill, predictable feature.

Answer 12

IR 8-10%,

Factors 12-10x

Question 13

Expected investment return (IR) varies for different types of business. What would be the expected IR and Factor for an old, established business in a highely competitive industry, significant hard assets, stable earnings, experienced and stable management, excellent goodwill, predictable feature.

Answer 13

IR 11-15%

Factor 9-7x

Question 14

Expected investment return (IR) varies for different types of business. What would be the expected IR and Factor for an a highly competitive bsuiness with few hard seets, small by experinces managerial staff and good historical earning record

Answer 14

IR 16-20%

Factor 6-5x

Question 15

Expected investment return (IR) varies for different types of business. What would be the expected IR and Factor for a small business dependent on the expertise of a very few people or large companies in highly cyclical industries without predictable or stable profits.

Answer 15

IR 21-25%

Factor 5-4X

Question 16

Expected investment return (IR) varies for different types of business. What would be the expected IR and Factor for a small personal service business with a signle owner?

Answer 16

IR 26-30%

Factor 4-3x

Question 17

What is the adjusted book value method?

Answer 17

concentrates on a company assets and liabilities rather than income.
- adjusment of values assigned for each of the firms assets and libailities from their historical costs to their current FMV.

Question 18

What is recasting financial statements?

Answer 18

process that brings statement more in line with the true ntature of the company;s current financial position.

Question 19

ABV method for analyzing a balance sheet is useful which kinds of business?

Answer 19

1. real estate development firms who derive income from buy and selling holdings at FMV
2. holding companies that own other business or income producing investments
3. firms that are marginally profitable and have a value comprised mostly of their liquidity
4. firms that have large asset bases and those that own property not used in the function of the business

Question 20

When do you use Alternative methodologies?

Answer 20

situations when the business may not be long-established or may not have financial statements.
-typicall analytical approach such as family-owned company

Question 21

What is the discounted future earnings method?

Answer 21

variation of the capitalization of earnings technique, but the emphasis is placed on future earnings instead of historical performances
- good for businesses without a track record of earnings

Question 22

How do you perform the discounted future earnings method?

Answer 22

1. determine expected business profits future a future period of time.
2. discount future earnings to their present value by multiplying the expected profit times the discount rate for each year.
3. discount rate = rate of return an invester could expect
4. 5 years of discounted profits are added together to arrive at the present value of the business.

Question 23

What is the price to earnings (P/E ratio)

Answer 23

• useful situation where closely-held business is the subject of the valuation exercise.
• hard to determine FMV.
• comparison from one company to others that are similar is done to analyze a relationship between earnings and the price of the comparable company.
• Ratio is then applied to earnings of the business to be values.

Question 24

What is the similar property method?

Answer 24

value of a similar company recently sold on the open market can serve as an estimate for a business currently undergoing valuation.

Question 25

What is Goodwill?

Answer 25

an intangible asset that increases the value of a company as a resul of name, reputation, customer, loyralty, location, product or toher factors.

Question 26

How can you measure/record goodwill?

Answer 26

1. excess difference between FMV of company assets and the FMV of the organization as an entity
2. excess difference between the return on a company assets invested at current rates of return and actual profits produced by the business.

Question 27

True or False

goodwill is usually noted only on the balance sheet of the company as an asset.

Answer 27

True,

Note deduction of a company’s goodwill on their income statement can be a clue that the company is not as financially healthy as it once was

Question 28

What is the value of human capital?

Answer 28

valuation of management expertise of a company executives and the tech skills of the rank and file employees

Question 29

what are examples of closely-help firms with unique tax advantages?

Answer 29

sole proprietorships and partnerships, an subchapter C and S corporations
- income taxed once and income is passed through the company to the business owner.

Question 30

What are the major changes on the financial statements of a closely-held business?

Answer 30

1. profits are likely to be understated in situations where most or all income is paid out to the ciompany owners
2. personal expenses may be included, delivertaly or otherwise in the financial statements are busiess expenditure.

Question 31

What are some unique features about farms and financial statemnets

Answer 31

principal asset = land,

-characterized as a tangile, renewable resource and is carried on the financial statements at historical cost.

Question 32

How can farmland be valued?

Answer 32

according to present use or potential use.

- IRS has special rules that govern the valuation of farmland.

Question 33

40% of start-up business survive the first 5 years. What are the most critical factors affecting business survival?

Answer 33

1. amount of time the company has existed
2. financial strength
   more capital = longer its been in operation.

Question 34

What 5 characteristics thrive the potential for new company’s continued survival?

Answer 34

1. cash flow
2. management expertise
3. technical expertise
4. capitalization
5. debt load.

Question 35

What needs documented need to be used to assess the value of a start-up company ?

Answer 35

pro-formal financial statements

business plan documents

Question 36

what is included in a small business administration of the US governments

Answer 36

1. executive summary
2. market analysis
   3, company description
3. company organization and management
4. markerting sales and management
5. service or product line
6. funding request
7. financials

Question 37

What is a business continuation agreement (buy-sell agreement)

Answer 37

agreement to specify the rights of all the company co-owners and to provide an agreed-upon method of valuing the business interest.

Question 38

What are some benefits to a propoerly constructed buy-sell agreement?

Answer 38

1. means of determining an equitable price for the business interest
2. mechanism for liquidating and disposing ownership interests.
3. prevention fo the sale of the business to outsiders
4. determination of a binding price for estate tax assessment
5. a price and liquidation mechanism for divorce proceedings

Question 39

There are 3 types of buy-sell agreements, what is a cross-purchase

Answer 39

remaining business partners agree to purchase the business interest of the deceased or departing partner for a specified proiice

Question 40

There are 3 types of buy-sell agreements, what is an entity agreement?

Answer 40

used by corporations.

coroporation will be obligated to purchase the shares of stock from the estate of the deceased

Question 41

There are 3 types of buy-sell agreements, what is a one-way buy-sell?

Answer 41

rare

older business owner (sole proprietor or stockholder) wans thte business inherited by specific beneficiary.

Question 42

What are items of financial underwriting that are of concern?

Answer 42

1. lack of a buy-sell agreement for established companies or lack of a business plan for a new business.
2. no discernible relationship among the amount of insurance applied for, business valuation, and results of financial companies. All factors are inter-dependent and relationships should exist.
3. financial data which raises the question about the company’s fiscal well-being, especially poor profit levels, declining sales, no financial rations and high debts can not be sustained.