“Adjusting” numbers sounds a little shady, doesn’t it? Well, it’s not. Not only is it legal, but it’s also the essence of the science of valuation. To analyze and compare attributes of companies, it’s appropriate to add or remove various financial data or apply various computations to get a true economic picture of the business versus the picture of the business for tax purposes. Adjusting is what accountants and business valuation professionals do to fully examine assets and companies as a whole.
This post overview the needs for adjusting financial statement for business valuation purpose, and provides tips on what to adjust and how to perform it. Enjoy!
Common Reasons For Adjusting Financial Statements
Here are some common reasons for adjustments of figures in the valuation process:
Removing non-operating assets – In any sale transaction, you have some assets that aren’t related to the production of earnings, such as excess cash. Those assets are generally not made part of the deal. For this reason, valuation professionals usually adjust the balance sheet to remove these items before making any comparisons.
Getting rid of nonrecurring income and expense items – A target company’s financial statements may be affected by events that aren’t expected to recur, such as asset sales, costs or proceeds from a lawsuit, or an unusually large one-time gain or expense. Valuation professionals take these items out so they can get a better view of management’s expectations of future performance.
Making sure that wages, benefits, and rent reflect current market rates – When a company does its due diligence in hopes of taking over another company, the potential buyer may find that the owners of the target company are paid wages and benefits either above or below market rates. Or the rent of the target company’s property may not match market rates. If the acquiring company is going to replace that management or staff, or if it’s not going to continue operating on the same premises on the same terms, the acquiring company may have to pay more or less to do so.
North American Industry Classification System [NAICS] codes — are a research tool to understand performance figures for various industries. These six-digit numeric codes are assigned by the governments of the United States, Mexico, and Canada to identify thousands of types of business establishments. The U.S. Census Bureau collects the data here in the States. You may hear the term SIC code — that’s the older version of the system, but that data is still out there. For more information, go to www.census.gov and do a search for NAICS.
What To Adjust and How?
As you’re applying various methods or approaches to the valuation process, you need to have a clean view of the company’s financials first. Adjusting financials is a critical step. You need to watch for plenty of items when you’re adjusting financials; if you see anything you don’t understand, ask a trusted advisor such as a Certified Public Accountant. Adjust for the following:
Calculate the inventory turn ratio or days’ inventory ratio for all the years that you have financial statement for. The trends in these ratios may indicate either an improvement or a slacking off in cash management. Sharp reductions in turn or increases in days’ may indicate a sudden downturn in sales, a new product line that’s stocking up, or obsolete inventory because a product line was abandoned, among other things.
Comparing the ratios to industry norms may offer valuable insights into the quality of cash management and potential risk. Always ask to see physical inventory records to see whether they correspond to the book numbers. Take a look at inventory adjustments, too; sometimes companies make inventory adjustments when their financial data doesn’t agree with the numbers collected in physical inventory. If you see these adjustments happening, ask why. They may indicate a management problem in the warehouse, but they may also point to unreliable financial data.
Be sure to ask how inventory is valued —LIFO (last in, first out) or FIFO (first in, first out). LIFO inventory accounting assumes that the last goods purchased are the first sold and that what remains in inventory at the end of the year are goods that were purchased first (and possibly bought at lower prices). FIFO inventory accounting assumes that the oldest remaining items are the first sold. Depending on the business and what constitutes its inventory, you may find a lot of undiscovered value within the inventory.
Granted, this is money coming in the door, but you need to find out whether any amounts in receivables can’t or won’t be collected by the time of sale. Comparing the inventory days’ ratios for each of the financial periods being analyzed provides valuable information about the quality of the receivables. And comparing the ratios to industry norms provides a perspective on how well the business is being managed relative to its competitors and helps you see the business in terms of relative risk.
Also ask to see an accounts receivable (AR) aging report to determine the quality of receivables. Look at the write-off history and whether the business has any AR insurance in place.
As with most hard assets, the purpose in valuation is to discover what they’re worth right now, not their book value, which doesn’t account for depreciation. You need to determine whether to price these assets at market value, replacement cost, or liquidation value. If the company is healthy, market value probably will be your choice. If not, it’ll probably be liquidation value. An independent appraisal of the assets may be required, depending on whether the assets are an integral part of the funding of a deal.
Adjusting Factory Equipment and Tools
Older manufacturing businesses may have equipment on the factory floor that’s in good working order but decades old. Unless the equipment is specialized and supplies a very lucrative product line, most of these assets are generally heavily depreciated. An independent appraisal of the assets may be required, depending on whether the assets are an integral part of the funding of a deal.
Adjusting Real Estate
This category is easy for most individuals to understand. Company-owned real estate is valued similarly to residential real estate — it’s almost always sold at market value. If a company has added sensible improvements and maintained its real estate well over the years, this category can be a source of great value . . . in a healthy real estate market. If the evaluation is being performed for a sale of the business, consider whether the seller may benefit from selling the real estate separately from the business.
Adjusting Year-to-year Numbers
One of the ways to judge consistency in a company’s financials is to divide the dollar amount of any item on the balance sheet by the total assets for that year. See whether those numbers are generally within a certain range or if they vary wildly. Do the same for items on the liabilities or stockholder’s equity side of the balance sheet. What if you see a lot of variance? You need to ask questions.