VALUING A BUSINESS

There are many occasions when a business needs to be valued. When a person approaches a bank manager for a loan, the manager will want to know the value of the business. A person thinking of buying a business will want to know if the price is reasonable. A person selling a business will want to know how much to ask. A person in the throes of a divorce settlement which includes a business will want to know the value of the business. A partner in a business that is being dissolved will want his share valued. It is usually necessary to value a business at date of death.

Common folklore has it that there is a formula or rule-of-thumb for valuing a business. One hears of 50% of the turnover or five times the net profit. Do not rely on these methods. If they give you a realistic figure, it is only by chance.

The following steps will apply irrespective of the reasons for valuing a business. Your first step in valuing a business should be to get copies of the Financial Statements for the past five years. The owner of the business should have these. It not, his accountant/tax agent will have them. Now, get some 14-column analysis sheets. These can be obtained from any business stationer. Let us assume that we are valuing a shop. Leave a blank column next to each headed column. Head up the columns Gross Sales, Gross Profit, Gross Profit %, Overheads, Net Profit. Go through the Financial Statements and write in the details for each of the past five years under these headings.

Now examine the Financial Statements to see if wages for the owner have been charged each year. Most likely, you will find that they have not. Ascertain from the owner how many hours he has worked on average in the business over each of the past five years. If his or her spouse has also worked in the business, you must obtain similar information. Now determine what the wages for a similar manager/employee would be. You can phone the Commonwealth Employment Service or your local Arbitration Inspectorate to find out the applicable Award wages. Now head up an additional column entitled "Owner's Wages". Enter the owner's wages for each of the five years. Do not forget to take account of inflation and only enter the wages that would have been paid in that year.

Now look at the Financial Statements and see if rent has been charged for each of the years in question. Very probably, it has. However if the premises are owned outright or are in the process of being bought, then no rent will have been deducted. In that case, you would have to ascertain what would have been an economic rent for each of the five years. Head up another column called "Rent" and enter the rent for each of the five years. If the premises are being purchased, then mortgage interest will have been deducted. In that case, head up another column called "Mortgage interest" and enter the mortgage interest charged for each year.

Now head up another column "Adjusted Net Profit". For each year, calculate the Adjusted Net Profit after deducting Wages for owner (if any) and Rent (if any). If any mortgage interest has been deducted, you must add that back to the Net Profit to arrive at the Adjusted Net Profit. Now you know your true Net Profit for each of the five years. It may surprise you.

But we are not finished yet. We have taken no account of inflation. If, in fact, the profit had remained static over the five years, nevertheless our figures would show it increasing each year because of inflation. We must therefore correct the figures to take account of inflation. Phone the Australian Bureau of Statistics in your State capital and ask for the CPI figures at 30th June for each of the past five years. You will now have to adjust all of the figures for the first four years to the CPI figure at 30th June of the latest year. You will remember that I asked you to leave a blank column by the side of each headed column. The Gross Profit % column, of course, does not need to be adjusted. Now calculate the CPI adjusted Net Profit for each of the years. We have now completed our examination of the Income Statement.

Now let us proceed to the Balance Sheet. First, take the Assets side of the Balance Sheet. List out all the asset headings on one column. For example, suppose our Balance Sheet looks like this.

BOOK VALUE REVALUED
NON-CURRENT ASSETS
Land and Buildings 100,000 150,000
Equipment 30,000 20,000
Vehicles 20,000 15,000
CURRENT ASSETS
Stock 10,000 7,000
Debtors 5,000 4,000
Balance at bank 3,000 3,000
Cash on hand 1,000 1,000
TOTAL ASSETS               $ 169,000 200,000

We revalue each of the assets and insert the value in the second column. A Real Estate agent can be consulted for the value of the Land and Buildings. For Equipment, the tax written down value can be accepted for each item except where this figure is blatantly untrue. A Motor dealer will supply the current value of vehicles. Stock must be counted and valued at cost price by reference to latest invoice, catalogues etc. Old, obsolescent and slow-moving stock must be written down to realistic prices. For debtors, the ledger card or computer account for each debtor must be examined. All amounts outstanding for over three months must be regarded as doubtful. A realistic estimate of the amount that will eventually be collected should be made.

Now let us look at the Liabilities side of the Balance Sheet. Suppose it looks like this.

BOOK VALUE REVALUED
Capital account of owner 109,000 148,000
Long term loan 50,000 42,000
Trade creditors 10,000 10,000
TOTAL LIABILITIES   $ 169,000 200,000

   

You ascertain that the long-term loan is from the bank and that the accountant has dealt with it by including the full amount of the loan, including all interest, as a liability. Consequently, the loan is overstated. You phone the bank and ask for the pay-out balance at Balance Sheet date. You are informed that it is $42,000. After all of the revaluations of Assets and Liabilities, we arrive at a revised Owner's equity of $148,000.

Now we must ask ourselves Have any assets been omitted? The most obvious asset omitted is Goodwill. Also, if the owner has any Patents, Trade Marks or Registered Designs, then they must be valued and included. If the owner is trading as a company, the company "shell" or formation costs may have a value, possibly around $1,000. A registered Business Name may have a value. A lease may have a value. Now ask yourself Have any liabilities not been included? What about employees Long-service, annual and sick-leave entitlements? What about taxation liabilities such as Group tax and the personal liability of the owner to Balance Sheet date? What about any loan guarantees to third parties made by the owner? What about any litigation pending?

In the sale of a small business, it is not usual to sell Vehicles, Debtors, balance at bank and cash on hand. The seller usually pays off all loans and creditors.

How do we calculate the value of the Goodwill? Many people think there is a formula, based on turnover, to calculate this. This is not true. The answer really is fairly simple. Let us take an example. Suppose you have $100,000 to invest. If you put this money in a bank at present, you will get approximately 5% interest i.e. $5,000 per year. If you were to invest it in buying a business, you would expect at least a similar return i.e. a Net Profit of $5,000 per year. The Net Profit of $5,000 would be, of course, after paying wages to yourself for working in the business. But there is a greater risk attached to money invested in a business compared to money in a bank. Because of the greater risk, you would expect at least 15% interest. Let us suppose that the business you have in mind makes a Net Profit of $70,000 per year before taking out any wages for the owner. What is the value of the business? Let's say the wages of a manager (yourself) would be $30,000. As we said above, you would expect a return of 15% p.a. on the investment.

Net Profit 70,000
less owner's wages 30,000
TRUE NET PROFIT  $ 40,000

Expected return on investment is 15% p.a.

Value of business is 40,000/15 X 100 = $266,667.

This means that if I invest $266,667 at 15% pa, I will get $40,000.

Now, assume that the business being valued is the business shown above. It is obvious that the owner's equity of $148,000 equals the total assets of $200,000 less outside liabilities of $52,000. What is the value of Goodwill? It is the balance of the purchase price.

Owner's equity 148,000
Balance i.e. Goodwill 118,667
Value of business      $ 266,667

When valuing Goodwill, bear in mind that what you are really paying for is future income. If there is a high probability that the Net Profit made in past years will continue in future years, then you put a high value on Goodwill. On the other hand, if there is a lesser probability that the Net Profit made in past years will continue in the future, then you put a lesser value on Goodwill. The past is merely an indication of what is likely to happen in the future. The key question to ask yourself in placing a value on Goodwill is 'What is likely to be the Net Profit of the business for each of the next five years?'

There could be a myriad reasons why the profit is likely to be less in the future. Customers may have a personal attachment to the present owner and may leave on a change of ownership. Long-serving employees may not continue with the new owner. New competitors may be starting up. Chain supermarkets may be about to enter the area of service. A highway may be in the process of being re-routed. The area may be in decline. The recession may be affecting the type of customers who patronize the establishment. The industry may be in decline. The abolition of tariffs may affect the trade. Cheaper imports may affect the business. New technology may be affecting the business.

When valuing Goodwill, you should be aware that certain industries are more risky than others. Consequently, a greater return will be expected on risky industries and this will depress the value of the Goodwill. For example, small builders and transport undertakings are notorious for going bankrupt. By contrast, newsagencies are regarded as very stable. There will be a lesser risk factor attached to a business that is long-established compared to a newly established business. It is a sad fact that some 80% of small businesses cease trading in the first five years.

What is the value of the Goodwill when the business just breaks even after paying a reasonable wage to the owner? Before the recession started, I would have said that the business had no Goodwill value. All you would be doing is buying is a job, paying award wages, and such a job could be had anywhere for the asking. But since the recession started, jobs are difficult to come by. A person will pay money for a job these days. This is the secret of the success of many of the one-man franchises being promoted at present. Retrenched middle managers are buying themselves a job with the proceeds of their redundancy cheques. In these recessionary times, I would place a value of $5,000 on the Goodwill of any business that is just breaking even. What about if the business is showing a loss after charging reasonable remuneration for the owner? Is there any value to be placed on the Goodwill in these circumstances? There may be. Suppose the business has been long established, it has advertised extensively, it is well known, it has agencies and it has a good turnover. A person desirous of entering the market and starting from scratch would have to incur a lot of start-up expenses. He would have to expend time and money in obtaining premises, hiring and training staff and undertaking extensive advertising. He could shortcut all this by buying the "shell" of a business. Consequently, he is likely to pay something for the Goodwill of a business that is actually incurring a loss. And if he thinks that he can turn the business around by better management and make a profit, then he is likely to pay even more for the Goodwill.

What are the tax implications of Goodwill? All assets, with some exceptions, bought after 19th September 1985 and subsequently sold at a profit are subject to Capital Gains tax. Goodwill is regarded as an asset. The profit on the sale of Goodwill is subject to Capital Gains tax. But from the profit is subtracted 1) the CPI increase and 2) 50% of the balance.

An example will make this clear. John Smith buys a shop on the 1st July 1990 and sells it on the 30th June 1992. He pays $100,000 for the Goodwill and sells the Goodwill for $150,000. How much of the Goodwill receipt of $150,000 will be subject to Capital Gains tax? The CPI index at 1st July 1990 was 103.3 and at 30th June 1992 was 107.3. Therefore, the cost price of $100,000 is increased by the CPI factor to $103,872. Consequently, the adjusted profit on sale of Goodwill is $46,128. However, only half of this is subject to Capital Gains tax i.e. $23,064. This will be taxed at the rate applying to John Smith's upper ordinary income. For example, if his other income was between $36,000 and $50,000 then the Goodwill of $23,064 would be taxed at 48.4% i.e. tax paid would be $11,163.

It should be pointed out that any asset that is likely to increase in value and to be subject to Capital Gains tax should not be held by a company. If held by a company, because of the vagaries of the Imputation system, it means that the full capital gain will be subject to capital gains tax. No deduction will effectively be given for 1) the CPI increase and 2) the 50% deduction.

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Copyright 1994.

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