EBITDA – Drawbacks

Part III

This is Part III in a 3-part series.  Please read Parts I and II before continuing:

EBITDA – Part I  standard formula and income statement adjustments
EBITDA – Part II  balance sheet impact

There are several business financial attributes required for EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to work well as a basis for the multiple of earnings method (the method used with the Market Comparable Valuation Approach); see Fair Market Value  for a better understanding of the three primary business valuation approaches.  The business attributes are as follows:

* Historically Stable Earnings  – several years of accurate financial statements specifically the income statement depicting stable income and consistent changes (growth or decline).
* Fundamentally Sound Balance Sheet – asset and liability groups remain relatively constant over three or more years; ratios are reasonable given the nature of the industry.
* Appropriately Capitalized – specifically the equity section is greater than 25% of all assets on the balance sheet.

The first two articles illustrated how the case study of White Diamond Marine Inc. introduced all three tests for financial attributes and their relationship to EBITDA.  This article illustrates how the three attributes negate the reliance on EBITDA as a sound basis to use in valuing White Diamond Marine Inc.  There are financial indicators in each attribute to invalidate EBITDA.

To illustrate how ineffective EBITDA is with this case, let’s first reconstruct the financial statements using the changes identified in Parts I and II for both the income statement and the balance sheet.  Note the correct EBITDA is $63,270.  I’ve inserted letters in parenthesis beside the correct value and attached a legend to explain the respective change.

.              WHITE DIAMOND MARINE INC.
.                               Balance Sheet
.                             December 31, 2015
ASSETS
Current Assets:
.    Cash                                             $21,206 (A)
.    Accounts Receivable                  26,979 (B)
.    Inventory – Boats                         96,402 (C)
.    Work in Process (Reams)            55,000 (D)
.     Prepaid Taxes                               23,402 (E)
.     Sub-Total Current Assets                                   $222,989
Fixed Assets:
.     Transportation                            $42,900
.     Equipment                                   163,902
.     Piers/Docks                                    80,000
.     Accumulated Depreciation     (179,714)
.     Sub-Total Fixed Assets                                         107,088
Other Assets:
.     Land                                              $50,000
.     Legal (Netted)                                  8,740 (F)
.     Sub-Total Other Assets                                          58,740
TOTAL ASSETS                                                     $388,817

(A) Cleared the line of credit for $50,000 based on the economic equivalent principle.
(B) Write down accounts receivable for the following amounts: 1) Reams contract $7,500, 2) Smith’s uncollectible note discounted $13,230, 3) Dartman’s slow payment discount $2,992 and 4) Family member (Hancock) issue $1,590.
(C) Inventory for parts is zero; moved to income statement as a function of equipment in Cost of Sales.
(D) Actual costs to date of $43,488 plus an accrual of $14,000 to complete the work less $2,488 assigned to Cost of Sales for cost overrun on Reams contract.
(E) White Diamond Marine Inc. prepaid taxes of $23,402 with an actual loss after adjustments on the income statement.  WDM is entitled to a refund of the entire amount paid.
(F) $4,000 of legal fees were paid on Reams contract and transferred to the expense section of the income statement.


LIABILITIES
Current Liabilities:
.    Accounts Payable                         $20,101 (G)
.    Accrued Payroll                               10,904 (H)
.    Accrued Work in Process               14,000 (I)
.    Floor Plan                                          88,000
.    Contract Deposits/Billings            55,000 (J)
.    Sub-Total Current Liabilities                                 $188,055
Long-Term Debt:
.    Crane Note                                      $89,753
.    Mortgage                                         121,602
.    Shareholder Note                                 -0-     (K)
.    Sub-Total Long-Term Debt                                     211,355
TOTAL LIABILITIES                                              399,360
EQUITY

.    Common Stock                                $1,000
.    Capital Paid in Excess                      4,000
.    Retained Earnings                            (5,148) (K,L)
.    Current Earnings                             (10,395)
.     Sub-Total Equity                                                       (10,543)
TOTAL LIABILITIES AND EQUITY                $388,817

(G) Added an additional $6,000 for the electronic radio/radar system.
(H) Added $3,000 for labor to repair the crane.
(I) $14,000 reserved and accrued to Work in Process and to this accrual to finish the work on Reams contract; includes labor and parts for a total of $2,488 cost overruns transferred to Cost of Sales.
(J) Reduced $7,500 to match Work in Process and adjusted to accounts receivable to remain in compliance with Reams contract.
(K) Transferred shareholder note to Retained Earnings to correctly state the equity value of the business; due to thin capitalization.
(L) 2014 income taxes were reported in 2014; therefore a correction to prior year income is required decreasing retained earnings.

.                        WHITE DIAMOND MARINE INC.
.                                     Income Statement

.                       12 Months Ending December 31, 2015
REVENUE:
Sales                                                $767,887 (M)
Service                                              301,299  (N)
Marina Fees                                        64,402
Sub-Total Sales                                                   $1,133,588
Other                                                                               4,601
TOTAL REVENUE                                             1,138,189
COST OF SALES/SERVICE/MARINA:
Boats                                                $612,394 (O)
Labor                                                  166,505 (P)
Equipment                                           22,602
Parts                                                    102,724 (Q)
Repairs                                                  23,211
Sub-Total Cost of Sales/Service/Marina              927,436
GROSS PROFIT                                                       210,753

EXPENSES:
Management                                   $110,301
Office Operations                               27,200
Facilities                                               14,103
Communications                                   3,711
Insurance                                                 9,615
Taxes and Licenses (Business)         10,767 (R)
Other                                                      11,137  (S)
Sub-Total Expenses                                                   186,834
OPERATIONAL PROFIT                                          23,919

CAPITAL COSTS:
Interest                                                 $23,702
Depreciation                                           6,210
Amortization                                           4,402
Sub-Total Capital Costs                                              34,314
PROFIT (LOSS)                                                           (10,395)
TAXES                                                                                -0-      (T)
NET PROFIT                                                              $(10,395)

(M) Reduced sales of boats $29,500 for Smith note double count, Smith note discount and Hancock’s  family issue.
(N) Reduced service sales $2,992 for Dartman’s discount on accounts receivable balance.
(O) Included cost of warranties ($8,902) with cost of boats sold
(P) Estimated labor accrual for crane repair is included.
(Q) Includes parts of $19,117 for the crane accident, $6,000 for the radio/radar bill yet to be received, and $2,488 for cost overruns on the Reams contract.
(R) Removed state income taxes and estimated extension payment for $10,536 for tax year 2014.
(S) Added legal fees of $4,000 for Reams contract.
(T) Taxes are zero due to a net profit loss; the company may be entitled to a tax credit via loss carry back against past income.

As a recap, EBITDA is as follows:

Operational Profit                                       $23,919
Less interest earned                                       (1,310)
Add floor plan interest in boat deals            31,204
Add depreciation in equipment for crane       9,457
EBITDA (Fully Adjusted)                          $63,270

If a buyer and seller agree to a multiplier of 2.5 White Diamond Marine Inc. is worth approximately $158,175.  Do you think this business is worth $158,175?

To evaluate EBITDA a buyer needs to look at the underlying fundamentals of EBITDA and if is applicable in this case.

HISTORICAL STABLE EARNINGS

In Part II (EBITDA – Buyer Beware) I identified $10,233 as payment to the corporation’s state department of revenue for income taxes for the tax year 2014.  Assuming the state’s tax rate is 6% (common tax rate for most states); the profit would approximate $170,550.  Federal income taxes are estimated at $38,750.  Therefore net profit after federal and state income taxes for 2014 is approximately $121,550.

In the original balance sheet for White Diamond Marine Inc. the retained earnings was a negative $21,723.  To derive this value, the company had to pay dividends of all the net profit plus more; or there were significant losses carried forward from 2013 (unlikely because WDM paid income taxes for 2014 and therefore no losses existed to offset earnings for tax purposes).  To have a profit of $170,000 in 2014 the business either sold a lot of boats or the owner didn’t take a salary in that year.  Look at management expense in 2015.  Notice it is $110,301?  Office operations would seem to have the bookkeeper’s wages included in the $27,200 value.  So most likely the owner didn’t pay himself in 2014 and did in 2015.

Assuming the owner didn’t pay himself in 2014, adjusting profit down $110,000 would change profit (before taxes) to $60,000.  Assuming similar interest, depreciation and amortization of $35,000 like 2015, operational profit was around $95,000 in 2014.  Here is the schedule:

Operational Profit by Year
2013                Unknown
2014                 $95,000 Estimated
2015                   24,000

Does this look stable to you?  Clearly a big change in two years.

SOUND BALANCE SHEET

A sound balance sheet refers to an enterprise’s ability to pay current bills, maintain long-term debt and have working capital available to address common business circumstances.  Let’s look at each one independently.

QUICK RATIO

The q is the best barometer of an ability to meet immediate needs of the business.  Basically the inventory is not counted in current assets and with dealerships, the corresponding floor plan is excluded too.  White Diamond Marine Inc.’s current assets now equal $126,587 and the current liabilities is equal to $100,005.  So the ratio is:

Quick Ratio = Adjusted Current Assets
.                       Adjusted Current Liabilities

Quick Ratio = $126,587/100,005

Quick Ratio = 1.27

This is unacceptable.  In the dealership industry the quick ratio needs to be above a four.  The reason is the interest on the floor plan.  Go back to the EBITDA calculation; the interest for the floor plan was $31,204 assigned to the units sold.  This means the floor plan needs at least $2,500 per month for interest service alone.  This is why quick ratios must be higher in the dealership industry.

It gets a little better for WDM if you remove the Reams contract issue from the books.  Technically with WIP at full contract price and the Contract Billings at full contract price; the two negate each other and can be removed in the formula.  Since the two cancel each other out, let’s remove them and recalculate the quick ratio.

Quick Ratio = $71,587/45,005

Quick Ratio = 1.59

Overall it is still not enough current asset resources to handle the liabilities that exist.  Don’t forget, there are two liabilities that are not posted in the current section that are current in nature:

1)  Interest on the floor plan of approximately $31,000 due during the next calendar year
2)  Debt service on the two long-term notes over the next twelve months estimated at $28,000

After considering these two unrecorded obligations the quick ratio drops to .68 (point 68).

No matter which quick ratio a buyer believes is appropriate, none will satisfy the basic business tenant of an appropriate current assets to current liabilities relationship.

For the longer term relationships, a buyer looks at the fixed assets to long-term debt relationship.

FIXED ASSETS TO LONG-TERM DEBT RELATIONSHIP

This relationship is built on a matching principle used in business.  In general, an owner of a business uses financial leverage to purchase equipment and use the equipment to make money.  Ideally, the book depreciation will match the loan principle amortization.  Let’s take a look at this in more detail:

There are two loans and three distinct asset groups.

Fixed Asset Groups            Cost Value     Loan Value
Transportation                          $42,900            -0-
Equipment (Crane, Other)        163,902         $89,753 (Crane Note)
Land/Piers/Docks                     130,000         121,602  (Mortgage Note)
.                                               $336,802       $211,355

Since there is no depreciation schedule there is no way to allocate out depreciation.  So the buyer can only look at the aggregate picture.

Fixed Asset Book Value                          $336,802
Accumulated Depreciation to Date          (179,714)
Net Value of All Fixed Assets                   157,088
Loan Value                                               (211,355)
Net Book Equity in Fixed Assets            $(54,267)

On paper the fixed asset equity position is upside down.  In effect when a buyer purchases White Diamond Marine Inc., the buyer is only interested in the fixed assets NET of debt.  If the EBITDA formula is a good formula, then the buyer wants the following assets:

* Title to the land/piers and docks
* Title to the crane, other equipment and transportation equipment
* Rights to the facilities lease, technicians and staff
* Assumption of marina leases with current tenants
* Current assets net of current liabilities including cash, accounts receivable and prepaid taxes

To successfully transfer all assets net of liabilities the existing owner will have to pay off the two notes with the proceeds from the sale.

Earnings Multiplier Method Value (EBITDA as basis) =      $158,175
Less Principle Value of Both Notes                               =       (211,355)
Owner’s Contribution to Sell the Business                    =       $(53,180)

Based on the above, the owner(s) of White Diamond Marine Inc. will need to bring $53,000 to the closing table.

So overall the balance sheet has serious issues.  First the quick ratio is extremely low.  Secondly the debt exceeds the book value of fixed assets by $54,000.  Does this make sense?  Well another way to understand this is to look at the equity situation.

EQUITY

One of the most difficult aspects of small business is capitalizing the operation during the early years of business.  White Diamond Marine Inc. is a perfect example.  In the equity section the business is currently negative driven by the loss from the current year (2015).

In business this is referred to as upside down.  Some novice business owners will use the term ‘Bankrupt‘ which is incorrect.  Bankruptcy is a legal status and unless the owner(s) has filed the necessary federal papers the business is merely upside down.  Again, minimum capitalization for a dealership operation is 25% of the total assets.  For White Diamond Marine Inc. the equity should not be less than $97,200.

The conclusion for using EBITDA as a valuation approach for this particular business is definitely inappropriate.  So what valuation tool is the better?

CONCLUSION

The cash flow valuation approach is extremely sophisticated and more attune to small businesses with greater revenue streams and volume of sales.  In addition there is more consistency in earnings from one year to the next and in general there is steady growth.  Most likely the best approach is a simple fixed asset valuation approach.  This approach will most likely require an appraisal for the land and pier system.  But given the relative age of the existing note, I can’t imagine the value being significantly greater than the current book value.

To illustrate I will use equity of $50,000 (appraisal is $50,000 higher than original cost) just to enlighten the reader to the fundamental issue at hand:

Asset                             Book Value      FMV
Cash                               $21,206        $21,206
Accounts Recvb             26,979          26,979 (Discounted Already)
Inventory – Boats              8,402            8,402 (Net of Floor Plan)
Prepaid Taxes                  23,402           23,402
Fixed Assets (Net)       157,088         207,088 (Appraisal Value)
Legal Organization          8,740               -0-    
Total All Assets          $245,817       $287,077

* Note intangible asset of financing and organizational costs has a zero FMV because there is no value to a buyer.
* Work in process is 100% set-off by Billings on Reams contract

Total Net Current Liab   45,005            45,005
Long-Term Debt            211,355          211,355
Total All Obligations   256,360          256,360
Net Value                      $(10,543)         $30,722

The reality is that at best, White Diamond Marine Inc. is worth $30,722 contingent on the appraisal coming in $50,000 higher than book cost value; which is highly unlikely.

EBITDA in the market comparable approach is an appropriate estimate of value once all income statement and balance sheet adjustments are considered.  However there must be several appropriate financial attributes in existence in order to rely on using EBITDA.  This includes stable earnings, a sound balance sheet and appropriate capitalization.  Without these attributes other valuation approaches must be considered.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns