Broker Chapter 9 Basic Business Appraisal 1
Learning Objectives Describe the characteristics of the legal entities a business appraiser may encounter List at least 5 reasons for a business appraisal List the 5 steps in the business appraisal process Describe at least 3 specific problem areas in a financial statement that may distort the firm's true economic value 2 2
Learning Objectives Explain the differences between cash basis accounting and accrual basis accounting; Calculate the important financial ratios List and describe the 4 approaches to estimating business value 3 3
Similarities to a Real Estate Appraisal Estimate market value Differences Appraiser must be able To read Understand Interpret financial statements inventory valuation It may be necessary to be able to value intangible assets such as goodwill, licenses and franchises 4 4
Business Appraisal Definitions Going concern - value of a business as an ongoing enterprise Liquidation value - consistent with a forced or hurried sale of the business assets 5 5
Reasons for a Business Appraisal Contemplated sale or purchase of a business Allocation of value to specific assets E.G. The sale of part of the business Financial reporting purposes Buy-sell agreements Liquidation of the business Divorce 6 6
Reasons for a Business Appraisal Estates and inheritance tax Beneficiary of the estate gift receives the gift free of tax Tax is paid by the estate Basis of property received is the fair market value at the time of death Condemnation proceedings Determination of insurable value 7 7
Business Appraisal Process Define the assignment Establish the date of the appraisal Collect the data Analyze the data Prepare the final estimate Prepare the appraisal report 8 8
Report Includes Summary and conclusions Purpose of appraisal Definition of value estimated Insurance, cost, market, etc. Description of subject business Appraisal effective date Description of appraisal process Summary of facts derived from data Statement of conclusions Assumptions and limiting conditions Supporting data, maps, financial statements and other exhibits 9
Financial Statements Balance sheet Statement of financial position at a point in time Income statement Gives the results of operations over an accounting period 10 10
Problems with Accounting Principles Estimates are necessary Assets are reported at cost Book value is original cost less depreciation Excluding land Appraisers should restate value to market value Valuation accounts do not reflect value Assets or liabilities may be missing 11 11
Accounting Methods Cash Accrual Income is recognized when received Expenses are recognized when paid Income is recognized when earned Expenses are recognized when incurred (liable) 12 12
Inventory Costing Methods First-in, first-out (FIFO) Produces the higher gross profit in periods of rising inventory costs Last-in, first-out (LIFO) Produces the most conservative estimate of gross profit in periods of rising inventory costs 13 13
Analyzing Financial Statements Construct historical series of financial statements Calculate financial ratios over time current assets current liabilities = Current Ratio Current assets Cash or any item that will be converted to cash within the next 12 months Current liabilities Due for payment within the next 12 months and paid with current assets 14 14
Understanding Financial Statements Current Assets Inventories Current liabilities = Quick Ratio Cost of goods sold Inventory = Inventory turnover ratio 15 15
Understanding Financial Statements Company Liabilities Tangible Net Worth = Debt to Worth Ratio Net Profit Total Capital = Net Profit to Owner Capital Investigate unusual items and results Vertical analysis is a review of various income and expense categories relative to a business s gross profit 16 16
Valuation Purposes Adjusted balance sheet Assets and liabilities Consistent with the industry Market value balance sheet Assets and liabilities at market value rather then cost 17 17
Understanding Financial Statements Adjusted income statement: States income and Expense items In a manner consistent with industry standards Pro forma income statement (projected) Estimate of operations for the next year Most important income statement when using the income approach to value estimation 18 18
Valuation Methods Sales comparison approach Price to sales ratio = selling price / annual sales Price to earnings ratio = selling price / annual net income Cost approach Income approach Liquidation approach Anticipated proceeds from the sale of all tangible assets - liabilities 19 19
Valuation of Intangible Assets Goodwill Business Personal Separable intangible assets Franchises Licenses Copyrights Leasehold benefits Trademarks 20 20
Methods of Valuation Estimate the value Tangible assets Intangible assets Business Personal goodwill Techniques Excess profits approach Market residual approach 21 21