What Does the Business Appraiser Do?

The Balance Sheet of a business is the financial summary of the stated assets and liabilities of the business as of a specific date. The Statement of Operations (or Income Statement) shows the activity in the business over a period of time, such as a monthly or yearly period. With few exceptions, businesses with revenues, costs of goods (or services) sold, overhead and administrative expenses, and some level of earnings are considered going concerns. These two financial documents comprise the essence of financial statements seen in 1120 or 1120S tax returns of an incorporated business. Think of a bathtub: The Balance Sheet is a snapshot picture of the water level in the tub, while the Statement of Operations measures the water that has gone in and out over time.

Accountants may also prepare a Statement of Cash Flows in compilations, reviews, or audits. Unincorporated businesses ' which can be bona fide marital assets ' are often tricky and difficult to analyze because tax records only contain 'Schedule C' summaries of operations with no reference to assets and liabilities 'owned' by the business. Even recognizing the broad confines of generally accepted accounting principles (GAAP), rarely do any two companies follow exactly the same set of accounting practices in keeping their books and preparing financial statements.

In the balance sheet, assets are ranked in order of liquidity: cash, accounts receivable, inventories, fixed assets, and 'other.' Liabilities are ranked in order of demand for payment: accounts payable, short-term notes payable, and long-term debt. A higher proportion of the 'more liquid' elements is favorable and enhances value. The measurement of Working Capital, or Current Assets less Current Liabilities, is a normal gauge of business health. Keep in mind that some of the balance sheet entries are based on tax-oriented concepts such as depreciation, where the acquisition cost of a machine or building, for example, is lessened in reported value based on estimated useful life. Accepting depreciated value of tangible assets as a surrogate for fair market value in continued use is a common source of material error in valuation. Unrecorded assets and liabilities, usually intangible in nature, are not shown on the balance sheet because, quite simply, they are unrecorded by the accounting and bookkeeping methods.

What Does the Business Appraiser Do?

Conventional theory requires the business appraiser to consider business value from three perspectives: Asset, Market, and Income. Each of these 'approaches' has a variety of methods. Oftentimes the Asset-based analysis is summarily dismissed because GAAP accounting rarely shows goodwill that would attach to the ongoing enterprise. In theory, each business asset and liability, including those intangible in nature, must be 'marked to market' and the result added up. An asset approach requires a difficult and tedious process, and is often called a 'bottom up' analysis.

In contrast, the Market and Income Approaches are 'top down' analyses because they begin with an element of the business' going concern nature from the Statement of Operations. Various levels in the earnings cycle can be used, usually some level of operating cash flow like EBITDA (Earnings before interest, taxes, depreciation and amortization), net income, or a measure of after-tax cash flow. The selected level of earnings is multiplied by a factor (or, divided by a capitalization rate) that is derived from fundamental market-based comparisons of sales of similar securities to yield value of the enterprise. (Yes, even an income approach is grounded in publicly traded securities!) Using market and income methods, the appraiser assumes that the combination of operational assets and liabilities held by the business are necessary to produce the level of earnings in the equation, so normal assets and liabilities are not adjusted back to value. This step in the procedure is where the plot thickens, and should be carefully scrutinized by the matrimonial attorney. Appraisers need to judge the quality of potential future earnings based on the risk profiles of the company-owned assets and liabilities. Does the balance sheet portray a company in a 'fat' or 'lean' position?

Adjusting for Excess, Underutilized, and Unreported Balance Sheet Items

The potential for leaving money on the table exists when a business appraiser arrives at a conclusion of value from a market and/or income method and assumes that all of the recognized assets and liabilities that the business owns are necessary and sufficient to produce the earnings cycle in the future. Some appraisers refer to this problem as an element of judging the 'quality of earnings' or the 'earnings capacity' of the business. It can be dangerous, however, to ignore the balance sheet of a business.

Consider the two extreme examples in Table 1 (below). Let's presume that the businesses show operating histories that are essentially the same, with revenues of $2 million and 'earnings' of $200,000. Capitalizing the $200,000 at 20% (equivalent to a multiple of 5) suggests value of the enterprise at $1 million. In Company #1, there appears to be an abundance of assets, although the $1 million in value less $900,000 of 'book value' suggests enterprise goodwill of $100,000. In Company #2, it appears that the business is staring into the face of bankruptcy. If this latter business is worth $1 million, enterprise goodwill must be $1.2 million! But remember, looking at raw historical operating performance ' accounts receivable and payable ' these two businesses look almost the same. Are both businesses worth $1 million?

In Company #1, an inquiring attorney might pose certain questions to the appraiser:

• Is there excess cash, or evidence of marketable securities that are unneeded in the business?
• Is there unneeded inventory?
• Did you consider the existence of unnecessary working capital?
• How were the fixed assets of the sports cars and the condo ski lodge treated? Would these be necessary in the eyes of a hypothetical buyer to sustain operations?
• Did you consider appropriate de-preciation of the equipment to reflect utility in use?
• Is there underutilized equipment owned by the business?

How did you consider the investment in Company X? Is this required to produce future earnings? (Note: some distributors are required to have an investment in a separate company that acts as a bulk buying agent; these 'other' company investments are normally required for operations.)

Is the cash value of life insurance (or the life insurance itself) necessary for operations? Why does the Company own this policy? Is the reported cash surrender value as calculated by the insurance company similar to what a viatical investment buyer would pay for the rights to collect the policy upon the insured's death?

In Company #2, similar questions might be explored to conclude that the Company was not over-valued, suggesting the illusion of more value than what really should exist.

• Is the stated cash and inventory sufficient to run the business?
• Would a potential buyer have to consider adding more working capital in order to sustain operations? (Working capital, or current assets less current liabilities, is zero. Should some value be subtracted to reflect needed investment capital to sustain the business?)
• Did you consider appropriate depreciation of the equipment to reflect utility in use? (With zero book value of fixed assets, does the old, possibly dilapidated equipment need replacement or major repair?)
• What clean-up costs would be associated with an environmental liability?

Concluding Thoughts

Appraisers who unthinkingly apply market and/or income multiples to earnings levels without considering the balance sheet are treading on dangerous ground. This requires subjective judgment and will be controversial. Anticipate that the wise appraiser will normally reflect this judgment in several ways:

• Separating the excess or non-operational asset from the normal operating assets and adding back the value of those excess assets to the earnings-based conclusion. Note that some excess assets, if treated this way, also have an influencing adjustment on the Statement of Operations. For example, tagging a condo or private plane as 'excess' also requires the removal of associated rent and maintenance expenses. Sometimes excess assets generate income, which must be adjusted too!
• Considering that a business, which has few assets and too many liabilities, may require a capital infusion by a hypothetical buyer in order to sustain future operations.
• Adjusting the multiple up or down based on the 'quality' or 'risk' to earnings. This procedure is more common in dealing with less quantifiable aspects, such as a superior partnership with distributors, or environmental contingencies.

Either a dollar-for-dollar adjustment to the earnings-based conclusion may be appropriate, or the multiple selected could be influenced. Even well-meaning accountants, who usually are well-versed in the ambiguities of finance, can fall into this trap of rote application of procedure without thinking 'does this make sense?'

The danger of leaving money on the table arises when there is evidence of unusual balance sheet conditions, and the appraiser provides no foundation in the opinion derived from market or income analyses to consider those conditions adequately. Sharpen your gun sights! Don't ignore the balance sheet in your appraisals!

[IMGCAP(1)]

Robert E. Schlegel, a member of this newsletter's Board of Editors, is a Principal with Houlihan Valuation Advisors in Indianapolis. He is an Accredited Senior Appraiser (Business Valuation) with the American Society of Appraisers and a Master Certified Business Appraiser with the Institute of Business Appraisers. Schlegel regularly teaches appraisal methods and financial ratio analysis to appraisers nationwide and to Indiana CPAs and attorneys.

In many divorces, the 'asset value' of business equity is the largest money piece of the divisible marital pie. Hiring a business valuation expert to appraise the equity, or rights, owned by the parties as of a date in time is normal practice. Yet sometimes there are issues underneath the valuation opinion that 'just do not seem right.'

Often, this can be traced to ignoring or minimizing the influence of the balance sheet while emphasizing the operating (or 'income') statement in market-based or income-based methods. Matrimonial attorneys need to scrutinize business balance sheets in depth and over time, in order to challenge a knee-jerk application of appraisal technique from a novice appraiser. Higher-risk businesses can be overvalued, and lower-risk businesses can be undervalued, leaving 'money on the table' that should have been divided or was perhaps divided in 'illusion.'

A Primer on Financial Statements

The Balance Sheet of a business is the financial summary of the stated assets and liabilities of the business as of a specific date. The Statement of Operations (or Income Statement) shows the activity in the business over a period of time, such as a monthly or yearly period. With few exceptions, businesses with revenues, costs of goods (or services) sold, overhead and administrative expenses, and some level of earnings are considered going concerns. These two financial documents comprise the essence of financial statements seen in 1120 or 1120S tax returns of an incorporated business. Think of a bathtub: The Balance Sheet is a snapshot picture of the water level in the tub, while the Statement of Operations measures the water that has gone in and out over time.

Accountants may also prepare a Statement of Cash Flows in compilations, reviews, or audits. Unincorporated businesses ' which can be bona fide marital assets ' are often tricky and difficult to analyze because tax records only contain 'Schedule C' summaries of operations with no reference to assets and liabilities 'owned' by the business. Even recognizing the broad confines of generally accepted accounting principles (GAAP), rarely do any two companies follow exactly the same set of accounting practices in keeping their books and preparing financial statements.

In the balance sheet, assets are ranked in order of liquidity: cash, accounts receivable, inventories, fixed assets, and 'other.' Liabilities are ranked in order of demand for payment: accounts payable, short-term notes payable, and long-term debt. A higher proportion of the 'more liquid' elements is favorable and enhances value. The measurement of Working Capital, or Current Assets less Current Liabilities, is a normal gauge of business health. Keep in mind that some of the balance sheet entries are based on tax-oriented concepts such as depreciation, where the acquisition cost of a machine or building, for example, is lessened in reported value based on estimated useful life. Accepting depreciated value of tangible assets as a surrogate for fair market value in continued use is a common source of material error in valuation. Unrecorded assets and liabilities, usually intangible in nature, are not shown on the balance sheet because, quite simply, they are unrecorded by the accounting and bookkeeping methods.

What Does the Business Appraiser Do?

Conventional theory requires the business appraiser to consider business value from three perspectives: Asset, Market, and Income. Each of these 'approaches' has a variety of methods. Oftentimes the Asset-based analysis is summarily dismissed because GAAP accounting rarely shows goodwill that would attach to the ongoing enterprise. In theory, each business asset and liability, including those intangible in nature, must be 'marked to market' and the result added up. An asset approach requires a difficult and tedious process, and is often called a 'bottom up' analysis.

In contrast, the Market and Income Approaches are 'top down' analyses because they begin with an element of the business' going concern nature from the Statement of Operations. Various levels in the earnings cycle can be used, usually some level of operating cash flow like EBITDA (Earnings before interest, taxes, depreciation and amortization), net income, or a measure of after-tax cash flow. The selected level of earnings is multiplied by a factor (or, divided by a capitalization rate) that is derived from fundamental market-based comparisons of sales of similar securities to yield value of the enterprise. (Yes, even an income approach is grounded in publicly traded securities!) Using market and income methods, the appraiser assumes that the combination of operational assets and liabilities held by the business are necessary to produce the level of earnings in the equation, so normal assets and liabilities are not adjusted back to value. This step in the procedure is where the plot thickens, and should be carefully scrutinized by the matrimonial attorney. Appraisers need to judge the quality of potential future earnings based on the risk profiles of the company-owned assets and liabilities. Does the balance sheet portray a company in a 'fat' or 'lean' position?

Adjusting for Excess, Underutilized, and Unreported Balance Sheet Items

The potential for leaving money on the table exists when a business appraiser arrives at a conclusion of value from a market and/or income method and assumes that all of the recognized assets and liabilities that the business owns are necessary and sufficient to produce the earnings cycle in the future. Some appraisers refer to this problem as an element of judging the 'quality of earnings' or the 'earnings capacity' of the business. It can be dangerous, however, to ignore the balance sheet of a business.

Consider the two extreme examples in Table 1 (below). Let's presume that the businesses show operating histories that are essentially the same, with revenues of $2 million and 'earnings' of $200,000. Capitalizing the $200,000 at 20% (equivalent to a multiple of 5) suggests value of the enterprise at $1 million. In Company #1, there appears to be an abundance of assets, although the $1 million in value less $900,000 of 'book value' suggests enterprise goodwill of $100,000. In Company #2, it appears that the business is staring into the face of bankruptcy. If this latter business is worth $1 million, enterprise goodwill must be $1.2 million! But remember, looking at raw historical operating performance ' accounts receivable and payable ' these two businesses look almost the same. Are both businesses worth $1 million?

In Company #1, an inquiring attorney might pose certain questions to the appraiser:

• Is there excess cash, or evidence of marketable securities that are unneeded in the business?
• Is there unneeded inventory?
• Did you consider the existence of unnecessary working capital?
• How were the fixed assets of the sports cars and the condo ski lodge treated? Would these be necessary in the eyes of a hypothetical buyer to sustain operations?
• Did you consider appropriate de-preciation of the equipment to reflect utility in use?
• Is there underutilized equipment owned by the business?

How did you consider the investment in Company X? Is this required to produce future earnings? (Note: some distributors are required to have an investment in a separate company that acts as a bulk buying agent; these 'other' company investments are normally required for operations.)

Is the cash value of life insurance (or the life insurance itself) necessary for operations? Why does the Company own this policy? Is the reported cash surrender value as calculated by the insurance company similar to what a viatical investment buyer would pay for the rights to collect the policy upon the insured's death?

In Company #2, similar questions might be explored to conclude that the Company was not over-valued, suggesting the illusion of more value than what really should exist.

• Is the stated cash and inventory sufficient to run the business?
• Would a potential buyer have to consider adding more working capital in order to sustain operations? (Working capital, or current assets less current liabilities, is zero. Should some value be subtracted to reflect needed investment capital to sustain the business?)
• Did you consider appropriate depreciation of the equipment to reflect utility in use? (With zero book value of fixed assets, does the old, possibly dilapidated equipment need replacement or major repair?)
• What clean-up costs would be associated with an environmental liability?

Concluding Thoughts

Appraisers who unthinkingly apply market and/or income multiples to earnings levels without considering the balance sheet are treading on dangerous ground. This requires subjective judgment and will be controversial. Anticipate that the wise appraiser will normally reflect this judgment in several ways:

• Separating the excess or non-operational asset from the normal operating assets and adding back the value of those excess assets to the earnings-based conclusion. Note that some excess assets, if treated this way, also have an influencing adjustment on the Statement of Operations. For example, tagging a condo or private plane as 'excess' also requires the removal of associated rent and maintenance expenses. Sometimes excess assets generate income, which must be adjusted too!
• Considering that a business, which has few assets and too many liabilities, may require a capital infusion by a hypothetical buyer in order to sustain future operations.
• Adjusting the multiple up or down based on the 'quality' or 'risk' to earnings. This procedure is more common in dealing with less quantifiable aspects, such as a superior partnership with distributors, or environmental contingencies.

Either a dollar-for-dollar adjustment to the earnings-based conclusion may be appropriate, or the multiple selected could be influenced. Even well-meaning accountants, who usually are well-versed in the ambiguities of finance, can fall into this trap of rote application of procedure without thinking 'does this make sense?'

The danger of leaving money on the table arises when there is evidence of unusual balance sheet conditions, and the appraiser provides no foundation in the opinion derived from market or income analyses to consider those conditions adequately. Sharpen your gun sights! Don't ignore the balance sheet in your appraisals!

[IMGCAP(1)]

Robert E. Schlegel, a member of this newsletter's Board of Editors, is a Principal with Houlihan Valuation Advisors in Indianapolis. He is an Accredited Senior Appraiser (Business Valuation) with the American Society of Appraisers and a Master Certified Business Appraiser with the Institute of Business Appraisers. Schlegel regularly teaches appraisal methods and financial ratio analysis to appraisers nationwide and to Indiana CPAs and attorneys.