Cash Basis

Cash statements are tied directly to the checkbook. If cash is received or spent, it is recorded. Revenues are recognized when goods sold are paid for by customers. Expenses are recorded when they are paid by the business. Receivables and payables are ignored and in its most pure form not even shown on the balance sheet. Again, in extreme cases, inventory is an expense when paid.¹ Typically equipment is recorded as capital assets and depreciated. Loans are placed on the books as liabilities. For small businesses with poorly trained bookkeepers, do check if the loan principal is being expensed as part of the loan payment. This is an error even for cash basis accounting.

Some analysts believe the cash basis or at least the ability to generate cash is the proper way to measure value. After all, cash available or distributed to investors and shareholders is viewed as the truest measure of earnings power and investor return. Yet, accounting periods are artificial. They involve cut-offs. Those cut-offs are necessary for reporting but do not really exist in time. Because we are working with defined periods and fairly short terms for small businesses, getting cut-off procedures correct is important for comparability. The lack of good cut-offs between periods is the major problem with cash basis accounting.

Cash basis is very simple. But simple is not always useful. For small restaurants and consumer service businesses that tend to be paid when service is provided and that do not have extensive inventory, cash basis can work quite well and provide credible measurement. For businesses with inventory or large receivables, cash basis can become quite misleading and difficult to compare results over time.

For instance, a company with a large inventory that has been expensed when purchased (therefor no inventory is shown on the balance sheet but it sits in the warehouse) may show no profit in the year that it buys large amounts of inventory. Yet it now owns a valuable asset in the inventory. Assuming the inventory is sold and NO new inventory is purchased, the company should be highly profitable the next year. Unfortunately, neither year's results are particularly useful. The first one's profits is understated and second one's profit is overstated.

The same thing happens with receivables. Many companies that provide goods or services to large companies do not get paid for 60 days or so. As the company is growing, these receivables consume all extra cash and on a cash basis reduce profit. If the company stabilizes or contracts and the receivables are paid, the company will show a high profit for a while.

Therefore, many cash basis companies can actually appear more profitable on their financial records even as they contract. This is not what is actually happening but because of the accounting method combined with short cut-offs, that is what the statements will indicate. The cash is being generated by assets being depleted – not from new earnings.

There are several ways to work with cash basis companies that have these issues. The first is by obtaining five years' data. Often the problems with cash basis will average out over time. Cut-offs are often the main issue. A one-year period is an accounting concept and cash basis does not address cut-offs. At the end of the year or other period, if checks are held to lower revenues and taxes, this will tend to average out over time. Namely, if $100,000 of checks are held at year end, the first year revenues are $100,000 lower. If the same amount is withheld, the second year revenues would be correct. If the company had a “bad” third year and did not withhold the $100,000 of checks at year end, then the company now overstated revenues by $100,000. While two of the three years could be materially inaccurate for valuation purposes, the average of the three or better yet five is likely to be reasonable.

Figure 11.1 is an example of averaging out cash basis financial information over a period of time. The information is further used to develop an estimate of current, year-end earnings. A common size income statement is used to better view the situation over time. In the case below, the averages look reflective of the future but that may not always be the case.

Another way to review cash basis statements when looking to adjust somewhat consistent intentional timing matters is to obtain the twelve months data for the year by month with a total column. This is an easy download in QuickBooks. It makes it easy to see the types of games cash basis taxpayers often play such as reducing income and increasing expenses at year-end. (Compare all months and particularly December and January for revenues and expenses.) Figure 11.2 is condensed, showing December and January entries for each year. This is a seasonal yacht maintenance business in North America so the reported monthly entries are unlikely to reflect actual collections.

If the company is growing or contracting through all periods reviewed, then the averaging process is less likely to be accurate. This solution is still likely to understate or overstate the amount of growth or contraction. Yet, it is still likely to be more accurate than any one period.

Another method is to attempt to convert the records to accrual basis. If accounts payable and accounts receivable records can be obtained for each period beginning and end, then simple math can be used to estimate the revenue understatement or overstatement. Simply subtract the beginning receivables from the ending receivables. If the number is positive, add it to revenues. Do the same with payables. If payables have increased, add the difference to the cost of goods sold or other expense. An example of this is shown in Figure 11.3.

The problem with this method is that many small companies have no idea what their receivables and payables are at any given date. Many small businesses do not enter the data until the payment is made or the check is cut, meaning they do not know their payables and receivables. (Worse yet, they think they do but they don't.)

If a supplier or contractor working for them bills late or if there is a dispute with the supplier or contractor, the payable may not have been entered at all sometimes for months. The same applies for receivables. There also is the issue of bad debts that needs to be investigated. Cash basis does not require recognition of bad debt. In some industries a certain level of negotiation and adjustment is expected. This can be very difficult to estimate if there is no history of the write downs. Professional judgment (again, this includes how does this compare to the treatment of what we are comparing it to?) is required to estimate those amounts particularly in the absence of data. See Figure 11.4 for an example of this type of adjustment.

One way to work with this issue with companies that track gross margins is to review the gross margin data over many years. This is most effective when the cost of goods sold mainly contains subcontractors and materials because these tend to be the long pay period items. If company's salaries are included in the cost of goods sold, the analyst may want to perform the same analysis, but removing salaries. Salaries tend to be paid quickly (compared to suppliers and subcontractors) and therefore are less of an accrual issue when a cash basis is used.² This will both serve as a check on whether “current” estimated accruals are likely to be correct and will provide back-up for any projections or adjustments necessary.

Note, as with all of these analyses, the level of valuation and the purpose are very important in determining if and how to use the data developed. An example of estimating the gross profit for the last seven years of a 12-year analysis is shown in Figure 11.5.

QuickBooks Issues

The QuickBooks system has become ubiquitous with small and very small business accounting. QuickBooks is a godsend compared to no bookkeeping but because it is so easy to start bookkeeping, many of the complexities of proper bookkeeping are not adjusted for.

All of the various problems in small business accounting mentioned above exist in QuickBooks. In addition, beware of the following:

• The tax accountant made adjustments shown on the tax returns but not in the QuickBooks file. Namely, make sure you pull data from the same source. Add-backs may be larger on QuickBooks. Make sure they tie through to the tax return.
• You have a QuickBooks file that says it is Accrual. Many, if not most, small businesses do not enter the data to have proper accrual records. If the data has not been entered, no matter what the title at the top of the report says, it is still not Accrual. This is pervasive. “Oh, you want accrual, I will just run you the accrual books from QuickBooks.” Beware and ask about accounting procedures that would be required to have real accrual records. If payables are entered as checks are cut and/or receivables are not tracked (or as often seen, tracked in another system), it is probably not accrual. In many industries, there are many revenue and expense recognition timing issues that need adjustment and entry in addition to pushing the accrual button, such as Work In Process adjustments, as discussed above.

Cut-Offs

For most small businesses getting the cut-offs correct is THE biggest issue with their financial statements. Check for all sources of cut-off error and make corrections or adjustments as necessary. A few errors to check for are presented below.

• Intentional cut-off error in order to reduce tax liability. Many accountants just shut their eyes or claim to not know. Ignorance seems to be bliss in these cases so don't just ask the accountant.
• Inconsistent data entry processes. Sometimes it is just general sloppiness or not realizing that it matters. Many small companies do not see the difference in entering payables or, when on the cash basis, sending checks between the 28th and the 3rd. Clearly that can impact period results.
• Financials run through today. Again, many “helpful” bookkeepers and owners want to run the financials through today. Often but not always these will show all revenues as sales are booked immediately by the company but expenses such as payroll and suppliers or contractors are only booked when paid or when the invoice is received. Therefore, the results are often too high. This is also why some owners are always surprised by their actual results. They always have a few weeks to a month more of revenues than salaries and most expenses. In short, the data through today is incomplete data which is often biased with every sale and not every expense. In general, work with internal data that is 30–45 days old so at least most data has been entered.

Beware of cut-off issues and adjust accordingly.

Accrual Basis

Accrual statements attempt to tie the timing of income to the timing of the related expenses. The advantage of this method is that, if performed accurately, it shows the earned profit the most accurately at every point in time. The biggest disadvantage is that management can be making a high level of profit and run out of cash. An accrual basis company (or any other basis) that does not pay attention to cash collections could go bankrupt even though they are profitable. View cash as blood. An otherwise healthy person can bleed to death. It is also why many small businesses use the cash basis. An otherwise healthy business can run out of cash.

Both cash flow in the short term and profitability in the long term are required for a business to survive and have value.

The disadvantage of the accrual method is, if required allocations are inaccurate, it is easy to distort earnings for a few periods in the short run. This distortion of earnings can be intended or unintended. Because of the complexities in making adjustments (generally known as accruals), inexperienced bookkeepers can have a difficult time producing accrual statements accurately.

As a general principle, revenue is recognized when earned. In general, it is “Earned” when everything expected for its receipt has been performed.³ Therefore in most cases when the invoice for payment goes out, so does the recognition of the revenue. In some industries, it could be 90 days before the cash is paid on the invoice.

Prepayments and deposits also occur. This is common in information technology businesses. Sometimes up to a year (or even three years with value-priced cloud-based businesses) of future service may be prepaid. Some industries receive large deposits. In proper accrual accounting, this will be booked as a receipt of cash and a liability for future work. As time goes by and the work is performed, the liability is then reduced and revenue is recognized. When working with financial statements of these types of companies, ask how these calculations are made. There will be adjustments in many cases.

In a similar vein, expenses are to be recorded as the work is performed or goods are sold. This is fairly straightforward with items such as payroll and rent that tend to be paid monthly or more frequently. But there are many other expenses that are not incurred necessarily when paid. The simplest is industries with 45–60-day payable cycles. 60 days is 16% of the annual cycle. That is a large material variance if the timing of the “booking” of the payables varies from year to year.

Capital asset purchases are generally understood not to be expenses by even untrained bookkeepers. A truck that will last five years is not fully expensed on a properly applied accrual basis when purchased. The purchase price will be placed on the balance sheet as an asset and the truck will be expensed over time on the income statement through depreciation. The depreciation will also reduce the value of the asset.

Some other common accounting issue are shown in the next few sections.

Loans. In many cases, capital assets will be purchased using loans. The loan provides cash to pay for the equipment. Loans often have three components: points paid when the loan is incurred, principal or the amount of the loan given, and interest also paid for use of the money. Points and interest are the price of the money and are to be allocated over the time the loan is in place. Except for major purchases, in many cases it is not worth allocating points based on materiality (this is not tax advice or bookkeeping advice, it is only advice on how to reasonably clean up these situations for performing a valuation). The interest is expensed as incurred. Most loans require monthly or quarterly payments. Beware of back-end balloon interest payments. While infrequent, this needs to be noted and it may materially impact the valuation both for current earnings and the ability to make the balloon payment and therefore perhaps even the going concern assumption of the valuation. This lump sum interest should be accrued as incurred even though it is not paid.

One thing that is often missed by bookkeepers and small business people is that loan principal is NOT an expense. In general, they understand that the cash received when getting the loan is not income. Yet, they often want to expense the principal payment. But it is a repayment. The loan principal is repaid with after-tax dollars from profits. This is something that needs to be looked at both to see the real cash flow to the business and to investors.

Insurance and Other Prepayments. Many companies pay business insurance on an annual basis. If the company is a retailer, general insurance and even workmen's compensation may not be that big a number. Construction and manufacturing companies can have very large liability and workmen's compensation insurance rates. These are often paid lump-sum annually. Under proper accrual accounting, this expense then needs to be allocated monthly. At the time of the pre-payment, the excess premium is an asset. Each month the amount used should be expensed and deducted from the remaining asset. Finally, if the company has this type of insurance payments and revenue is growing or falling sharply, check for the rate and base that the rate is applied to. These policies contain audit provisions that can increase the total cost significantly as revenues go up, particularly for subcontractors and other labor-providing companies in dangerous industries. This can be a very material adjustment to overall profits and value when applicable.

Software as a service and other expenses can have pre-payments or be pre-paid. Again, they need to be allocated in the same way as that explained for insurance above.

New or Lease Renewals with “Free Rent Periods”. The free rent period should be allocated over the term of the lease. For example, if the landlord gave six months' free rent and then the rent is $5,000 per month for five more years, the free period should be calculated ($30,000 = 6 x $5,000). The $30,000 should reduce rent by $455 (rounded) per month over the period ($30,000/66 months). This is a particularly material issue when the “Free” period is improperly booked in one of the periods under review. For example, rent shown for the year is booked at $30,000 (6 x $5,000) instead of $54,540 calculated as (($5,000 - $455)*12) because the company had six months' free rent in that period.

Retailers of Wholesalers Purchase Inventory for Sale. Inventory is an asset of the company on the balance sheet. Even when it has been paid for, it is not supposed to be expensed until sold or otherwise disposed of.

Inventory should be physically taken at least annually. Physical counts provide the best inventory method as they accurately adjust for shrinkage or theft. Many small companies never take inventory. If the business is small and simple, that may be manageable for day-to-day operations but it creates problems to really understand the cost of goods sold (COGS) and profitability of the company.

Inventory Methods

Most small businesses currently use a form of specific ID. Namely they track the actual item sold. Otherwise they tend to use first in first out (FIFO).

Few still use last in first out (LIFO). Unless the company has large excess inventory or stale inventory, this is unlikely to affect small business results. There is just not enough spread. Of course, on a liquidation basis, LIFO inventory may be understated and could be worth a higher percentage when liquidated than inventory under other methods. If LIFO is used, which is rare to see with small businesses, the inventory on the balance sheet, and beginning and ending inventories on the income statement would require adjustment to properly mark to market.

There are other inventory items to look for. Many small companies never write off stale, excess, or unsaleable inventory. If there is a significant adjustment in inventory, it needs to be reflected on the income statement as additional expense. If unsaleable inventory accumulated over many years exists, then perhaps the write-off should be deducted over multiple years for comparability.

In industries such as manufacturers or contractors that are making things, work in process or WIP, namely, the product being made is a form of inventory. In general, on smaller projects the work in process will be expensed as the completed units are sold. On larger projects like large construction projects taking months or years, the company may use percentage of completion method where the project revenues and expenses are recognized or written off as the work is performed.

Smaller inventory than actually exists––many companies overstate COGS in order to understate income and reduce taxes paid.

A related issue with the same likely outcome is when companies always use the same beginning and ending inventory. In effect, they are either over-stating or under-stating the cost of goods sold. A similar issue is always using the same percentage of cost of goods sold. Usually this is justified as being based on some sort of historical experience or overall mark-up. But it does not reflect likely changes in pricing due to premiums or more likely discounts to sell through inventory. In both cases it is very difficult to really understand the profitability of the business. If possible, a physical inventory should be taken. While it is only an ending inventory, at least a real number exists to use for adjustments.

Tax Basis Accounting

Tax basis accounting is a combination of cash and accrual accounting that complies with IRS guidelines for preparing taxes. Tax basis accounting will vary across industries. In some cases, it is similar to cash basis accounting though inventories are tracked and adjusted on an accrual basis. In some cases and above a certain size (currently $10 million), it will be accrual accounting. Even in that case, some adjustments to the financial statements such as depreciation rates will vary from the GAAP accrual accounting. Because most small business valuations are prepared based primarily on tax returns, the tax basis of accounting is frequently relied on.

Obvious other differences between normal accrual and tax basis accrual are that depreciation under tax accounting is much quicker than under most financial accounting including GAAP. In equipment-heavy industries the amount being written off under Section 179⁴ needs to be reviewed. Because the write-off does not appear on the business tax return income statement, it is not added back but it is also not deducted. It is often ignored.

When the owner is buying a small amount of equipment compared to the revenues and value of the business, ignoring the write-off is often immaterial. In equipment-intensive industries, Section 179 write-offs and depreciation need to be reviewed and may require adjustments for capital investment in the cash flow.

Adjustments will also vary with the valuation method being used. Market data from comparable companies was likely to be maintained on a basis similar to what you are seeing (assuming you are using small-revenue private businesses as comparables). Data from the income method, if material in amount, should be converted from tax depreciation to GAAP rates. (Fortunately, with small and very small businesses, it is rarely material.) In industries with large capital investment; the investments, depreciation, and the age of equipment must be carefully reviewed. Heavy reinvestment requirements will lower multiples, or be an adjustment to the cash flow, or may be a direct reduction in value, particularly if the fleet or equipment is very old.

GAAP

Generally Accepted Accounting Principles (GAAP) are the authoritative guide to accrual accounting in the United States. Very few small businesses comply with GAAP. GAAP is very technical and cumbersome for small and very small businesses to implement. If a small business has substantial outstanding bonds or loans, the bonding company or bank may require “Reviewed” or “Audited” financial statements conforming to GAAP.

Another new issue with GAAP statements is there are a number of clarifications and corrections in the form of new rules, including items like revenue receipt, showing equipment leases and real estate leases on balance sheets that may make it difficult to compare results over time.⁵ The jury is out on how this will affect financial analysis, including business valuation.

CPA Statement Levels

Certified Public Accountants (CPAs) are allowed to issue four types of statements. A new category, “Basic Financial Statement Preparation” has recently been introduced. Basic Financial Statement Preparation means the CPA took the client's data and formatted it. This is basically the same thing as working with client-provided data. A notice on each page must state that “no assurance is provided.” There is no report.

The next level is a “Compilation.” A compilation is when the CPA has compiled the records. Usually they will provide a very low level of checks to make sure things like loans are all properly reflected. While this is a low level, at least it is some minor level of third party check.

The next level is Reviewed. Reviewed statements are just that. The CPA has performed some very basic reviews to see that the data is sensible and correct. They have NOT performed audit procedures and are not attesting to the financial statements. Yet, at this level the statements do have some implied reliability. They often include notes to the financial statements. Be cautious of reviewed statements. Experience indicates that reviewed statements often imply a higher level of evaluation than occurred.

The highest level is Audited. Audited financials have had extensive checks made for completeness, accuracy, and correctness. But they are unlikely to disclose intentional fraud. For business valuations, these are the highest quality statements. Usually they comply with GAAP and they are well organized and complete. Unfortunately, they are very rare in the small business world. They are quite expensive and require many disclosures and extensive notes that many small business owners view as unnecessary.

Analyzing CPA-Provided Statements

When you receive financial statements from a CPA, the process to analyze them is straightforward.

• Start with the cover letter. Check on the level of work that is being performed. The cover letter will state if it is a compilation, a review or an audit. Read on what basis the statements are compiled: cash, income tax, accrual. Does it comply with GAAP? What are the variances?
• The cover letter will state if there are going concern issues and if the company is out of compliance from GAAP or other standard used. These notices can be big red flags. Investigate carefully.
• If the statements have notes, go there next. Read the notes. When complete, notes provide a wealth of information on real estate leases, debts, contingent liabilities, industry information, and so on. Notes are often the most useful part of reviewed or audited statements. Notes often contain details the company would like to keep hidden.
• Study the financials. Flip back to the notes to make sure you fully understand details.
• If Supplementary Schedules are attached, assess them. Often details on overhead accounts, cost of goods sold, breakdowns and other useful information are presented in supplementary schedules.
• Even with CPA-prepared financials such as compilations and reviews, investigate one-time add-backs and contingencies beyond the statements and notes. Some companies “manage” earnings which is sensible from their perspective but may not reflect true earnings power in the correct period. An example is a company that has substantial earnings from prior periods that it is not recognizing due to potential “contingencies” that did not appear to exist.

Unfortunately, very few small and very small companies have reviewed or audited financials. When available, they make business valuation much simpler because financial statements are clear, consistent, and notes provide a level of detail that can take many questions to uncover.

Assets

Assets are what the business owns, including the obligations owed to it.

Cash. Cash is generally retained by the seller in a very small business sale and is not part of the delivered assets. Cash is a component of working capital which will be discussed below.

Accounts Receivable. Accounts receivable are money owed the business for services that typically have already been provided. Small business owners will be quick to tell you that that this is their money because they already earned it. They sold and delivered the product or service. As discussed in Chapter 7, accounts receivable should be reviewed and in some cases adjusted for collectability.⁶

Of course, for many businesses, accounts receivable is a very necessary component of the business, just like the delivery truck. In some industries, particularly those with large clients the ability to wait for payment is very important to obtaining premium pricing on their work and to growth.

The market method databases generally specify that for asset sales the cash and accounts receivable will be retained by the seller and are not part of the purchase price in a sale transaction. Often the databases with stock sales assume a balanced working capital. Beware, in practice, as discussed elsewhere, neither of these assumptions is always or perhaps even generally correct. Accounts receivable are also a key component of working capital and will be reviewed below.

Inventory. The value of inventory is often added to the price for small businesses when using the market method. According to some transaction databases and most rules of thumb, the value of good and usable inventory is not included in the price. For small businesses this is often the case. See the section, Inventory, in Chapter 6, Market Approaches, for more ideas on how to adjust inventory for different size and types of businesses.

Other Current Assets. This is a catch-all account for payments due to the company in under one year. Often it will contain real estate deposits and the like. Technically a real estate deposit is not current (except during the last year of the lease) as it cannot be received back until the end of the lease. Technically it should be moved to Other Assets. Usually the amount is immaterial.

Fixed Assets. Fixed assets generally are equipment and vehicles. Tenant improvements also fall into this category. These should be marked to market. (If the real estate lease is unlikely to be continued, the tenant improvements mentioned above likely have a market value of $0.0.) Except in liquidations and for a few asset-heavy businesses the fixed assets of most small businesses have little impact on value. If fixed assets are a major contributor to value, it may make sense to bring in a real estate appraiser if it is real estate-based, or an equipment valuation expert, if it is equipment-based.

Liabilities

Liabilities are what the business owes to others.

Accounts Payable. Accounts payable are the short-term debts the company owes to its vendors. The significance of these is that they are a low-cost loan to the subject company. Yet many small businesses must pay much quicker than they are paid. In general, for small business sales, the market database assumption and real-world situation are that accounts payable are paid by the seller through the closing date.

Other Current Liabilities. This is often where taxes and payroll due reside. Unpaid retirement and other benefits also are shown here. In general, with smaller companies and asset sales, this is paid off. This can also contain lines of credit. Lines of credit are often secured by receivables and inventory.

Long-Term Debt. Long-term debt for small businesses are often truck, vehicle and equipment loans. They can be lines of credit depending on the terms and SBA loans also. Long-term debt is almost always personally guaranteed by the business owners. (Often accounts payable and the real estate lease may be personally guaranteed also.) Typically for small business sales as reflected in the market method data, long-term debt is typically paid off at the time of a sale and therefore needs to be deducted from the value found.

Contingent Liabilities. Contingent liabilities are liabilities that may or may not happen based on a contingency. Common contingent liabilities are loan guarantees on other people's or companies' loans (due on default by the other), uninsured claims in lawsuits with a likely chance of loss (due on loss of suit), and union pension obligations (usually due on sale of the business). If not revealed by the owner or management, these can be hard to find. Once found, it can be hard to determine proper adjustments.

In the case of loan guarantees, understanding the loan terms and the financial strength of the primary borrower is a starting point. For lawsuits, often the attorney handling the case will give an opinion letter assessing the likely outcomes. Finally, demand letters to the pension managers will produce estimates of the union pension liability. In many cases, these estimates, or a portion of them, would be adjusted from the value found.

Owners' Equity

Owners' equity is the sum of all the assets of the business less all the liabilities of the business. It should also total the equity investments in the business by the owners plus cumulative earnings of the business less cumulative distributions of the business. Therefore, as the name implies, owners' equity shows the owners' investment in the business. Owners' equity shows the worth of the business on a book basis.

Owners' equity indicates if the company has resources and resilience to survive downturns and change. Further regular distributions to the owners should be reviewed, particularly when valuing minority and lack of control interests.

Finally, the ability of the company to make money over time is the ultimate determinant of value. Regular distributions or increasing retained earnings in owners' equity is the surest sign of long-term growth.

Lack of Adjustments

Many accounting systems automatically make balance sheet entries. Many small business owners never make the other half of the entry, therefore the account over time becomes misleading.

Other areas are loan balances that are not reduced as payments are made. Depreciation adjustments that never get posted at year end. You may also find an account that is an ‘unidentified’ summary account or that accounts receivable have a credit balance instead of a ‘normal’ debit balance, and/or accounts payable have a debit balance instead of a ‘normal’ credit balance. For many of these types of adjustments, if the amounts are material to the value of the business, then the valuator must do the clean-up or have the business accountant or bookkeeper make adjusting entries.

Estimate of Working Capital

Many small businesses are essentially labor suppliers or material suppliers, or both labor and material providers to much larger businesses. In this role they often have to pay labor weekly or bi-weekly and pay suppliers on 30 to no more than 45 days terms. Yet they get paid somewhere between 45–90 days by their large clients. This financing is not poor cash management, it is an expectation in their industries.

This means, as revenues grow, so does required working capital. Namely, net current assets over current liabilities will grow and require more and more cash. For most small business valuations, it is important to estimate if the company will be able to generate the cash to invest. If not, the company will not grow at the projected pace or will go bankrupt due to cash shortages. This increase in working capital may also need to be adjusted in the cash flow.

The simplest rough estimate that is often sufficient:

• Obtain income statements, balance sheets, accounts payable aging and accounts receivable aging as of the same date. In addition to year-end, request balance sheets and A/R and A/P agings for another typical month in the year.
• If the company has seasonality, you may need to look at A/R and A/P agings several times during the year. Also check if suppliers give special terms in season. For retailers in some specialties, many vendors give payment terms of 90 days for Christmas season purchases.
• Do not just look at year-end data. Year-end data is often manipulated for tax purposes by cash-basis small and very small business owners.
• Review the ratio of salaries and wages to revenues over the three years. If the company has COGS, make sure you add the wages in COGS to the review.
• Usually wages will be fairly consistent with revenues. If not, estimate the cash increase or decrease based on the trend.
• In addition, check if there are large capital investment needs, borrowing needs or perhaps principal payments not showing that would modify the estimated cash flow gap. For most small companies which operate on little long-term debt and have policies of periodic replacement of their small amount of equipment, this is generally not a factor.

Then, for non-seasonal businesses, take the revenues and subtract profits (total costs). Divide by 12. This is the rough monthly cash needs of the business. Multiply this by the time it takes the company to collect receivables. Subtract typical payables. This is the working capital needed. Of course, this will vary month to month but if reasonable months are selected. it should be in the ballpark.

If the business is seasonal, this needs to be done in the busy and slow season. Payables need to be checked to make sure terms are being taken advantage of. In some cases, if available, this is done with monthly data. Often income statement data can be pulled out of QuickBooks. Balance sheet data will depend on the quality of the bookkeeper.

Construction contractors commonly have a withholding called retention. The purpose of retention is so the contractor comes back and completes the job 100%. It is often 5–10% of the revenues for the work. This can further exacerbate cash flow issues and the need for working capital. Some contractors keep retention in general receivables and many have a special category. If retention is in a special category, make sure to account for it in the working capital calculations. The easiest way to do that is to add average retention to the accounts receivable balance when doing the calculations above.

This can be done at several time points if necessary, to check consistency and develop an estimate. If this process is done several times over the period reviewed, a working capital ratio to revenues can be established.

Applying Working Capital in Forecasts

The working capital estimate can then be used to determine increases in working capital based on revenue growth. For instance, in the example above, when revenues are $6,000,000, working capital is $750,000. This means the working capital is 12.5% of revenues. So, if revenues are projected to become $8,000,000, the next year working capital is now $1,000,000. This could result in an adjustment of $250,000 in increased working capital. If company profitability does not support that level of re-investment of earnings, either growth is likely to be slower or third party lines of credit need to be investigated.

A more thorough estimate of working capital could be performed by examining historic working capital over the prior growth period and confirming if more or less is needed as revenues grow.

Of course, long-term growth for most small and very small businesses is very modest compared to the above example.

Applying estimated working capital requirements as calculated above directly to estimates of value for the capitalization of earnings and the market methods are addressed in Chapters 5, 6, and 8 of this book.

Estimating Capital Investment

It is hard from a purely “financial” perspective to estimate capital investments for many businesses. Many manufacturing businesses can run multiple shifts if necessary. New technologies can make perfectly operable equipment obsolete on an operating cost basis. Furthermore, in most businesses, capital investment is not an even steady state thing. Often large capital investments occur in chunks from time to time. Not in even drips or drops. This makes estimating a steady state capital investment adjustment very difficult.

To estimate capital investment, examine the prior capital investment. Often depreciation schedules will be the best source of this information. Note the age of equipment. If equipment is getting old, you may be able to obtain wear and tear indicators such as mileage on vehicles. You can also see how the current owner handles replacement. Some sell vehicles at 100,000 miles and some run them for 20 years and replace the engine at least once.

When estimating equipment needs for a manufacturer, try to get an indication of current volume and when the owner believes replacement or additional equipment will be required. This is something that often needs to be handled as part of the owner/management interview.

Take the information obtained from all sources and see how it ties into growth forecasts. If growth is not forecast, check on replacement costs. Make sure these are reasonably included in forecasts or in estimating the cash flow for the capitalization of earnings method.

In some industries, replacement cost may be factored into the market method multiplier. For instance, printers may require a lot of capital equipment investment. Printers always had a lower multiple (even before the internet) than some other businesses because of the high level of capital investment. In other industries, it may not. Use your judgment in trying to align the size and type of companies in the market data as compared to the subject company.

Owner Debt

Some small business owners are well advised. These owners will often fund much of the capital for their business with debt they provide as opposed to equity. In certain liability and creditor situations, if done properly, this can be advantageous for the owner.

In addition, as part of tax planning, sometimes the owner will lend money from the company to themselves in lieu of a distribution. In those cases, they are required to have a note and pay or accrue at least the legally required interest for IRS purposes. Of course, it raises this issue for business valuations – is a debt to or from the owner really a debt?

Clearly for legal purposes, in most states, if the debt has been properly set up, properly documented, and interest paid, the debt exists. There are court rulings in some states indicating that where no one would give a market loan to the company, the debt is really equity.

Excess Assets

Excess assets are assets that are not required by the company to generate the revenues and resulting cash flows that generate value for the company. Examples include vacation homes owned by the company (often for “entertainment”), personal vehicles, old or obsolescent equipment no longer used in production (of course, does this have a value at all?), gold coins, excess working capital and/or retained cash.

Conservative owners often keep excess cash on the balance sheet, just in case. I suspect it helps them sleep at night. Excess cash beyond reasonable operating needs should be treated as an excess asset.

Excess assets should be recast as non-operating assets on the balance sheet,⁷ it will not change the adjusted equity amount. The non-operating asset amount is required to be added to the value of the enterprise in the income and market approach analyses.

BIG Taxes

Excess assets held by C corporations may have a BIG tax on them. BIG taxes are built in gains. C corporations are separate tax-paying entities. Their tax effects do not pass through to the shareholders. Therefore, two sets of taxes are applied to money earned by C corporations. The tax at the corporate level and then the tax at the shareholder level. Pass-through entities, namely, partnerships, limited liability companies, and S corporations are only at taxed at the partner, member, or shareholder level.⁸

Common sense says that the estimated BIG tax should be deducted from the excess assets when adding the asset value to the estimated value using any valuation approach. BIG taxes are addressed in Chapter 7, Asset Approaches. If significant, excess assets might be subject to BIG taxes, it is dependent on the purpose and professional judgment of the valuator if they should be deducted from the value found in determining the estimated value of the excess assets. For instance, if excess assets are likely to be distributed as part of a settlement, then they likely should be at pre-tax values. If the valuation was for purchase or sale of a minority interest, then likely the excess assets would be shown at a post-tax value.