12 Sep Financial Statement Adjustments – Part 2
Written by: Matt Safft, CVA
(4 -6 minute read)
As discussed in Part 1 of this newsletter (www.reliantvalue.com/financial-statement-adjustments/), financial statements may not portray the economic reality of a business. While we already discussed the most common cash flow adjustments we consider, there are also adjustments which are often difficult to prove to be non-business operating. In Part 2 of this newsletter we will discuss these adjustments and why they are often not made in a business valuation.
Adjustments not Considered:
When determining appropriate adjustments it is sometimes suggested that we add back a portion of advertising expenses. In most cases, this is because the borrower feels they can achieve equivalent sales levels while removing outdated or unnecessary advertising methods being used. We usually cannot consider this to be an addback, as the appraiser cannot ascertain the importance of advertising expenses in revenue generated. For example, if a company expensed $40,000 of advertising expenses and generates $2,000,000 in sales it is hard to determine what the company’s sales would be if advertising expenses decreased to $20,000, and certain advertising methods were removed.
When valuing a franchise, Item 6 of the Franchise Disclosure Document typically will identify the required percentage franchisees are expected to pay in franchise–required advertising fees. Within the valuation, the appraiser will adjust advertising expenses to be equal to the amount on the franchise disclosure document when the subject company is paying a lower amount and the owner(s) or buyer(s) indicate advertising fees should be equal to the franchise disclosure document going forward.
Adjustments to RMA Averages
Appraisers use RMA industry data to compare the company’s performance to industry averages. This data can be used to analyze a company’s expense margins, or financial ratios, to see if the company looks to be stronger or weaker than the industry. However, these RMA averages are used for comparison, not to change the actual expenses of a company. If the appraiser were to adjust to RMA averages, the indication would be that any hypothetical buyer could operate the company at industry levels. Fair Market valuations must consider the current operations of the business.
It is critical to make sure the appraiser is following the standard of value of the engagement. Reliant Business Valuation typically uses fair market value for SBA engagement. In a fair market valuation, the appraiser must consider expenses, revenues, etc. that a hypothetical buyer would incur/receive under normal operations of the existing business. Although certain buyers may have specific plans to cut costs or increase revenue, a fair market valuation must consider what a hypothetical buyer would do and not the plans of one specific buyer.
Travel, Meals, Entertainment, Telephone
For certain small to mid-sized businesses, the current owner(s) may expense personal expenses through the company (i.e. family travel, meals, entertainments, cell phone). These addbacks can be considered by the appraiser; however, it is difficult to provide adequate proof for verification. For example, if the company was expensing personal telephones, it is hard to prove these telephones are truly not used for business purposes. Additionally, for meals and entertainment, it is very difficult to prove a certain amount of these expenses were not solely for business purposes (i.e. client or employee appreciation). As mentioned previously, for certain industries and in certain situations these addbacks will be considered if sufficient proof is provided to the appraiser.
In general, the purpose of financial statement adjustments is to ensure the analyzed cash flow is what a hypothetical buyer would receive (fair market value). The potential addbacks discussed above can lead to uncertainty about the impacts (Advertising/Marketing), do not justify a fair market value (Adjustment to RMA Averages, Investment Value), or are difficult to prove (Travel, Meals, Entertainment, Telephone). While this list is not exhaustive, it is a representation of adjustments that are proposed to us most often that we are unable to make.
If you have any questions about potential adjustments, please give us a call at 908-888-6030 and an appraiser will be happy to discuss.