DEBT Is a Four-Letter Word

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Kathy Hensley, CPA, and Rob Schlegel, ASA, MCBA, are with Houlihan Valuation Advisors in Indianapolis, IN. They have both worked on a wide variety of matrimonial assignments over the past 30 years. Mr. Schlegel regularly teaches appraisal methods and financial ratio analysis to appraisers nationwide and to Indiana CPAs and attorneys.

Has your divorce client's business been caught in the recent economic crisis? Most industries, such as retail, wholesale, construction, and services, are affected. Although there are a few exceptions, the presence of debt in a business elevates risk, which depletes divisible asset value. The presence of loaned money to the business (most often, from a bank) indicates leverage, or the concept of “using other people's money” to fund the business. Higher financial leverage is fine during periods of expansion and growth, but during contractions, high leverage actually penalizes a business and makes it more vulnerable to bankruptcy.

Matrimonial attorneys must be able to distinguish elements of leverage risk that are accentuated in today's economy in order to prevent overvaluing business equity. In some cases, common valuation techniques that ignore leverage can actually undervalue a business that is less risky and able to weather the economic storm. These latter businesses will be best positioned to take advantage of growth when the recession ends, and may be valued higher because of conservative strategies followed during 2007 and 2008.

A Brief Lesson 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 balance sheet is an integral part of the financial position of any business and should never be ignored. The Income Statement shows the activity in the business over a period of time such as a monthly, year-to-date, or annual period. Unfortunately, too many business appraisers concentrate analysis on the Income Statement alone and the generation of historical cash flows. The Balance Sheet gives the reader insight into whether the business has enough resources available to continue into the future during periods of economic downturn.

In plain terms, the business runs on invested cash (or capital) from two sources: 1) money that is “loaned” by the owner (Equity); and 2) money that is loaned from outside sources (Debt). Taken together, these sources of funds are called Invested Capital. The balance between Debt and Equity is called Capital Structure, commonly expressed as a percentage of Debt and a percentage of Equity of the Invested Capital. The higher the percentage of Debt within the Capital Structure, the higher is the leverage, i.e., using other people's money to fund the business.

The valuation expert must make an informed decision whether the business will be able to continue to earn money for the owner while paying the interest required for loaned money. In periods of economic recession, revenues shrink and earnings shrink, but debt obligations to the bank do not shrink. In fact, businesses that are highly leveraged may fall victim to an economic accelerator principle: If revenues fall ' say, 10% ' earnings could shrink by 50% or more because many costs involved in operations, including debt, do not change.

Consider the two simple examples in the chart below. Presume that the businesses show operating histories that are essentially the same, with historical revenues of $3 million and “net income earnings” of $600,000. Capitalizing the $600,000 at 20% (equivalent to a multiple of 5) suggests value of the equity at $3 million. This technique is an Income-Basis method, and presumes that all existing operational assets and liabilities are necessary to produce earnings. Both Company #1 and Company #2 have total assets “worth” $1.5 Million based on tax concepts of appropriate depreciation. However, Company #2 has five times more debt than Company #1. The interest paid by Company #2 is a legitimate expense of the business, and proper accounting will subtract this expense to yield “net income.” Remember, looking at raw historical operating performance, these two businesses look almost the same. Are both businesses worth $3 million?

The answer is “NO,” because the high debt in Company #2 makes the business more risky, especially in an economic downturn. Company #2 has only $200,000 in equity, one fifth of the $1 Million of equity in Company #1. Company #1 is better able to weather economic uncertainties; Company #2 is more risky.

Understanding Business Valuation Mechanics

Good business appraisers will see that market buyers penalize a highly leveraged Company that finds itself in a precarious position during an economic downturn. Value is predicated on the presumption of future cash flows, using information known, knowable, or reasonably foreseeable as of a specific date (such date of separation, date of filing, or date of hearing). As a result, good business appraisers will often derive a capitalization rate reflecting the leverage risk in the business from a Weighted Average Cost of Capital (WACC). WACC is actually the blended cost of capital from both debt and equity sources to the business reflecting risk.

While the financial metrics of constructing a WACC rate are complex, ultimately the business appraiser will derive a Capitalization Rate and apply it to expected Earnings Before Interest and Taxes (EBIT) of the coming year, and subtract existing debt. (It is possible to apply this WACC-derived rate to last year's earnings, but that presumes continuity of the business trends, which in today's recessionary environment is a rebuttable presumption.) The most interesting concept is shown in the graph below, indicating that as a company's percentage of debt of invested capital increases beyond a certain point, so does the required rate of return, or total cost of capital. The target point (with arrow) indicates the “best capital structure” or lowest WACC rate. During periods of economic recession, the “sweet spot” shifts to the left because of the higher risk of leverage.

Conclusion

Novice appraisers who unthinkingly apply income multiples to equity earnings levels without reflecting the amount of balance sheet interest-bearing debt are treading on dangerous ground in 2009. A debt-laden company that hummed along in prior years may not be able to sustain profitable operations in 2009 and 2010. Beware that heavy debt loads of “other people's money” are fine when good times roll, because a business with operational earnings of, say, 15% on revenues can pay off the banker at a 7% rate, and devote the difference toward a return on owner's equity. But during tough times, the reverse effect is true. If operating profit margins shrink to, say, 5%, paying off the banker at 7% means an accentuated contraction of return on equity. Pay attention to the debt component of your client's business because in today's environment, DEBT is a four-letter word!