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Basic Financial Terms for Business Valuation


It is one thing to understand the ultimate number realized by your business valuation expert. It is in another to understand how he or she realized that number. It is important that you, as counsel, be able to understand how such expert reached their conclusion so that you can better effectuate direct examination. Of even more importance is your understanding of the subject matter so that you can effectuate cross examination. If you don't have a solid understanding of financials, their terminology, and various approaches and methods used in the business valuation process then you better not even attempt cross-examination of a seasoned expert who has experience on the witness stand. That expert will tear you to shreds and you will be worse off for your attempt at cross examination. Thus counsel needs to at least have a rudimentary understanding of financial terminology so as to put on a proper trial. The same level of expertise will be needed to prove your point at settlement conferences. Thus don't take this information for granted. Lastly, know that I, Eric Roy, am not a certified public accountant. I write these articles for my, and my staff's, benefit. For a more thorough understanding of the material pick up one of the books written by Shannon Pratt and Alina Niculita as they are foremost authorities on the subject and a valuable resource. I obtain a great deal of my information, including the information below, from their writings.

As a starting point, you as counsel should understand the difference between a balance sheet and an income statement. These are probably the most common financial statements you will run across. The difference between the two financial reports is that the balance sheet consists of a description of assets, liabilities and owners' equity. Whereas an income statement represents revenues, expenses and income over a period of time. Remember that there are several layers of review these financials may undergo. Each layer realizes its own level of credibility. The three layers consist of audited statements, reviewed statements, and compiled statements. These are listed in descending order of reliability. The first of these, the audited statements are reviewed by an independent authority using generally accepted accounting principles (GAAP) and are accompanied by an opinion as to the fairness and accuracy of the statements under review. The reviewed statement, again conducted by an independent CPA, is given limited assurance that no material modifications need to be made to the statements. The last of these layers, the compiled statements, need not be prepared by an independent CPA. These are often prepared internally and thus provide the least amount of reliability.

A term that you will run across frequently when reviewing balance sheets is that of "common equity". Common equity refers to the value of all common equity or common stock held by a company. This does not include the value of preferred stock. Additionally, remember that all retained earnings add to the value of common equity. Thus it is an accumulation of retained earnings and common stock. Another term that you will run across is that of "invested capital". Invested capital is simply the total value of investments into a company. Remember that both stockholders, equity owners, and debtholders contribute to invested capital. By adding the total value of equity investment and long term debt acquired you can determine invested capital. Accountants will then go on to differentiate the proportionate invested capital in terms of both equity and long-term debt. The relative proportion of each is referred to as the "capital structure" and delivered as a percentage.

When we are discussing the balance sheet we need to know how to explain the value of the business's assets. The term used to define this value is "book value". To determine book value we first add up the value of all of the business's assets and then we subtract from that total asset figure the total accumulated depreciation on those assets. This in turn gives us a book value. Book value can then be reduced further to a per share basis. This is done simply by dividing total book value by the number of outstanding shares. The result of this calculation is the book value per share. The question may arise as to whether intangible assets should be figured into this book value calculation. The answer to this is that it may or may not be. Often times when a business creates its own goodwill it will not bother to include the value of this goodwill on the balance sheet. On the other hand, if the business purchases this intangible asset then it will include the asset on the balance sheet. This is significant in that because of this difference in recording intangible assets it can be difficult to make comparisons across industries or businesses if intangible assets are included in the book value calculation. Thus for the sake of simplicity intangible assets are often not used when calculating book value.

Another term you will come across is that of "net working capital". Net working capital is simply current assets minus current liabilities. Remember when we say "current" we are typically speaking of a period of no more than one year. Working capital thus lets us know the current state of liquidity for the business. If current liabilities exceed current assets then you have a working capital deficiency.

Reading the income statement you are going to come across expenses such as depreciation, depletion, and amortization. Understand that these are expenses on the income statement. However, although they are expenses, they do not require an actual distribution of cash.

There are a variety of different ways in which to describe income. Thus as a practitioner make sure you are on the same page as your expert as to what method was or is being employed. A couple methods you will see frequently include earnings before interest, taxes, depreciation, and amortization (EBITDA) and similarly but different earnings before interest and taxes. (EBIT) In the first of these you will add the value of accumulated depreciation back into operating income. This of course will result in a higher income value. In the later (EBIT), depreciation will not be added back onto operating income. Thus your total earnings, operating income, will be lower as it is a post depreciation and amortization number.

Gross cash flow quite literally refers to the total after tax cash flow. Thus we look at net profit, after tax. We then add to this net profit the business's total non-cash charges. Non-cash charges include amortization and depreciation. This is quite different than "net income" which describes income after all expenses, taxes, non-cash charges, and owner's compensation. Sometimes your expert will want to know what the "pretax income" of the business is. This pretax income is income post all expenses except for taxes.

A couple final terms to be familiar with include "net cash flow to invested capital" and "net cash flow to equity". The two terms are the same in that they both refer to an amount of capital, money, available to pay out to stakeholders of the company after recognizing sufficient capital to sustain operations of the company. The difference between the two terms simply lies in who the cash would be available for. In the net cash flow to invested capital we look at cash available to distribute to all stakeholders including holders of debt, preferred stock, and common stock. In the net cash flow to equity equation we simply look at the amount of cash which would be available to equity owners to withdraw. And thus debt holders and preferred stock holders withdraws are not accounted for.

Lastly, be familiar with "capital expenditures". Capital expenditures are those expenditures a business makes for purposes of acquiring new or improving upon existing assets such as equipment or property. These expenditures are typically expensed over time on the income statement. Changes to net working capital simply refers to what changes will need to be effectuated for purposes of sustaining operations. This may include an increase or decrease in net working capital.

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