In the article EBITDA the fundamentals of Earnings Before Interest, Taxes, Depreciation and Amortization were introduced. In general EBITDA is commonly used with the market comparable valuation approach. In that article it was illustrated how a simple income statement’s operational income increased $50,000 attributable to interest, taxes and depreciation based on the functional presentation and some improper bookkeeping. The end result benefited White Diamond Marine’s value in the formula.
This article will illustrate the opposite effect using the same business information. A buyer of a business should be leery of financial information and look for improper accounting processes. The goal is to reduce the operational income and ultimately the value of the business. The goal is to get the business valuation to a realistic number.
To do this I first will illustrate the financial statements using only the balance sheet and the same income statement used in the first article – EBITDA.
White Diamond Marine Inc.
December 31, 2015
Inventory – Boats 96,402
Inventory – Parts 19,117
Work in Process 43,488
Note Receivable 14,700
Sub-Total Current Assets $297,204
Accum. Deprec. (179,714)
Sub-Total Fixed (Net) 107,088
Legal (Net) 12,740
TOTAL ASSETS $475,934
Accounts Payable $14,101
Accrued Payroll 7,904
Floor Plan 88,000
Contract Deposits/Billings 62,500
Line of Credit 50,000
Sub-Total Current Liabilities $222,505
Crane Note 89,753
Shareholder Note 27,111
Sub-Total L/T Debt 238,466
TOTAL LIABILITIES $460,971
Common Stock 1,000
Capital Paid in Excess 4,000
Retained Earnings (21,723)
Current Earnings 31,686
TOTAL EQUITY 14,963
TOTAL LIABILITIES AND EQUITY $475,934
White Diamond Marine Inc.
For the Year Ending December 31, 2015
Marina Fees 64,402
Sub-Total Revenue $1,166,100
Other Revenue 4,601
Total Revenue 1,170,701
Cost of Sales/Service/Marina:
Sub-Total Costs 887,929
Gross Profit 282,772
Office Operations 27,200
Taxes & Licenses 21,303
Sub-Total Expenses 193,370
Operational Profit 89,402
Sub-Total Capital Costs 34,314
Taxes (Income) 23,402
Net Profit $31,686
Notice the operational profit is $89,402? In the first EBITA article, the earnings reported was adjusted upwards to $139,289 related to functional accounting presentation with the income statement and some errors from the bookkeeper. Now I’m going to adjust this $139,289 again. This time it will be adjusted for basic accounting principles. This article will cover the balance sheet as a whole, then address current asset issues, fixed asset depreciation, other asset issues and debt problems. All of them affect value from the perspective of a buyer.
Balance Sheet – Current Assets
White Diamond Marine’s (WDM) balance sheet is typical of your small business financial status. To start I always tell clients to look at the equity of the business. For WDM, total equity is $14,963. In business this is referred to as ‘thinly capitalized’. Technically the equity position is less than 4%! Automatically red flags are flying. Good small business capitalization is at least 25% and this is with dealership operations. Worse yet, look at retained earnings. It is a negative $79,000. Either WDM had losses in the past or the owner(s) distributed earnings as fast as he generates a profit.
Even if the business were to transfer the shareholder loan to equity, the equity position is still less than 10%. With an equity position this low, there are going to be issues. Let’s find them. In almost all cases, the problems exist in the current assets section of the balance sheet.
Since this is a marina operation having cash at year end is appropriate. There still remains three to four months of cold weather; therefore there will be no boat sales and most likely very little service work. Cash is needed to carry WDM until spring.
But look over in current liabilities. There is a $50,000 line of credit. Via the economic substitution principle the line of credit can be zero and cash is now $21,206. Basically the cash is used to pay off the line of credit, or on the last day of the year, the company drew $50,000 on its line of credit to boost the cash account balance (economic substitution). The only reason there is a strong cash position is because of the line of credit. WDM needs more cash to carry its operation to the Spring. Customers need to pay their bills. This takes us to accounts receivable.
WDM’s receivables are $52,291. The first thing any sophisticated businessman wants is an aging report. Here is WDM’s accounts receivable summary aging report by 30 day increments.
White Diamond Marine Inc.
Accounts Receivable Aging Report
Summary Format December 31, 2015
Name 0-30 Days 31-60 Days 61-90 Days >90 Days Total
Bruceton $742 $742
Compton $241 241
Carroll 179 179
Dartman $3,792 3,792
Hancock 1,590 1,590
Morris 142 142
Quigley $95 95 95 285
Reams 12,000 19,000 31,000
Smith 73 73 73 14,700 14,919
Thompkins (599) (599)
Totals $(431) $730 $12,910 $39,082 $52,291
Right from the start, the summary report is backwards. Customarily the 0-30 day column will have more than 80% of the balance. The 31 – 60 day column should be around 15% and only 5% of the A/R should be older than 60 days. For WDM, over 95% is older than 60 days. Some questions are warranted for the top four accounts. Here are the stories:
- Dartman – Mr. Dartman had his small outboard motor repaired back in July 2015. His credit card has been denied several times and he promises to pay. He has agreed to installments of $100 a month for now and has made 2 of those payments. His current balance is $3,792.
- Hancock – Mr. Hancock’s sailboat was lifted out of the water and the hull was power washed and repainted. He is currently in the Caribbean for the winter. Mr. Hancock is the owner’s cousin and owes $1,590.
- Reams – Mr. Reams signed a contract back in February 2015 to have his boat remodeled. The contract was for $55,000. As of August 31, 2015 a total investment of materials and labor for the project was $43,488 as shown as a current asset (work in process). Total billings on the contract is $62,500 as identified with contract deposits/billings in the current liabilities section. Mr. Reams has paid a total of $31,500 to date with a balance of $31,000 due. It is estimated an additional $8,000 of materials and labor are needed to finish the contract. Mr. Reams refuses to pay the amount due because he is dissatisfied with the quality of work and overcharges. To comply with Mr. Reams standards another $6,000 is required. This additional amount will have WDM in adherence with the $55,000 contract as agreed. A civil claim is currently in the early stages of legal action whereby a deposit of $4,000 has been made and recorded as one component of legal costs in ‘Other’ assets.
- Smith – Mr. Smith purchased a used boat back in May and did not qualify for the full value of financing. To make the deal work, Mr. Smith agreed to pay a separate short-term note to WDM on September 8, 2015 for $4,700. Mr. Smith did pay his interest and financing fee and is currently charged $73 per month for interest. Of the $1,310 of interest earned on his note, he has not paid $219. The note is unsecured and Mr. Smith does not respond to messages left on his phone. Mr. Smith has not even signed for the certified letter mailed to him.
Notice any problems here? Let’s start out with Mr. Ream’s situation.
Work in Process
This project is obviously a no win situation. At best WDM will pay an additional $14,000 to complete the job. A total of $57,488 will be invested for $55,000 of income. The projected loss is going to run $2,488. There is still more. The legal fees are already $4,000 and will most likely increase. As a buyer, a deduction to the EBITDA for $6,488 is a minimum amount ($4,000 of legal and an additional $2,488 for the projected loss on the project). All of this relates to 2015 calendar year. Since the receivables will be reduced $7,500 for the overcharges ( a credit entry) the corresponding contract deposit/billings account in current liabilities will receive the debit. This will have no effect on EBITDA (the $7,500 adjustment). The net result is a reduction to EBITDA for $6,488.
Next up is Mr. Dartman’s account. Although Mr. Dartman is paying on his balance of $3,792, no buyer is willing to wait 38 months to collect this; it is risky and unrealistic. Two options exist. First the $3,792 is discounted to a more appropriate value (about $800) or the owner’s of White Diamond Marine exclude the value from the earnings and take the account with them after the sale. In almost every case the discounted value is the negotiated result. Therefore an adjustment is generated equal to the difference. Total earnings adjustment is $2,992 (decrease).
The cousin (Hancock) is in the Caribbean and owes $1,590. Since this is a family issue, a buyer will want the entire amount adjusted to earnings. No discount is offered or even up for negotiation. With family transactions there really is no fair approach, therefore remove the value from the books. Deduction is $1,590. If the dollar value remains, the usual result is when the buyer goes to collect, the family member will say ‘but it is a family issue; he did the service for free’.
Now for the really big issue which is Mr. Smith’s note. Look at the current assets section of the balance sheet. There is a note receivable for $14,700. Look at the A/R summary report. Mr. Smith’s note has an original balance of $14,700. Coincidence? Highly likely they are one in the same. After questioning, it turns out that they are the same note. What happened is the original entry for A/R was created at the time of the sale and the second entry for the note receivable was generated once a copy of the note reached the bookkeeper’s desk. In both cases, sales was credited as a function of dual entry. Therefore sales is overstated by $14,700. This will reduce EBITDA significantly for purposes of calculating the correct value.
In addition the question at hand is ‘What is the likelihood of Mr. Smith paying his note?’ Buyers of businesses do not want this headache related to collecting money on an unsecured note. A secured note would warrant a 50 – 60% discount. An unsecured note is worth 10% at best due to legal costs and frustration involved. For the purpose of this calculation, the discount amount for this note is $13,230.
The balance sheet states there are $19,117 of parts. To an outsider this means parts for the service department to use in the normal course of business. An inventory is conducted and it turns out that $11,740 of the parts are actually for the boat crane. It turns out that the boat crane sustained damage to the main drive well hauling out a sailboat. The remaining parts are to repair the sailboat damaged by the crane. The insurance policy has a $25,000 deductible for damages during a lift or insertion function. WDM absorbed the costs without involving the insurance underwriter. In addition to the parts, it is estimated $3,000 of labor is required to complete the repairs. The reality is that there are no parts for service to customers. Therefore this asset is really equal to zero.
To properly account for this incident; repairs and maintenance in cost of sales/service/marina is debited for $22,117 and credits are issued to inventory-parts for $19,117 and accrued payroll ($3,000).
Balance Sheet – Fixed Assets
EBITDA excludes depreciation from the formula because the goal is to assess the operational income as if it were purely cash. It is somewhat similar to the highly sophisticated cash flow valuation approach. Since depreciation is a non-cash expense; it is excluded. It doesn’t matter whether the depreciation is accelerated or straight line. It is simply ignored.
However I want to point out a couple of interesting observations about White Diamond Marine’s fixed assets. In the long-term liabilities a mortgage note for $121,602 exists. Mortgage notes are used to finance real estate and their improvements. In the Other Assets section is an asset identified as ‘Land’ for $50,000. In addition up in fixed assets sits and asset of piers and docks for $80,000. Obviously the piers and docks are tied to the land. Since there are not buildings as fixed assets the office facilities and repair shop must be rented from a third party. This makes sense because there is a facilities expense on the income statement.
Here is a summation of this relationship:
Original Cost $130,000
Note Balance (121,602)
Equity in the Real Estate $8,398
There isn’t much value in the form of equity with the land component. It appears to be a recent purchase given the percentage of the note balance to the book balance of the assets purchased.
Balance Sheet – Other Assets
The land asset was explained above, ‘Legal’ includes organizational cost (which is amortized) and $4,000 of the value is the prepaid amount to a law firm in regards to Mr. Reams contract.
What are ‘Warranties’?.
When a large ticket asset is sold the dealership often sells warranties from third parties that offer some form of mechanical protection. White Diamond Marine sold 18 warranties. The revenue was included in the income statement but the cost for the warranty is posted as an other asset. This is wrong.
White Diamond Marine does not own the warranty, the boat owner is the holder of record. This $8,902 should be a cost associated with boat sales. This will increase cost of sales and decrease operational income.
Balance Sheet – Current Liabilities
Of the five accounts in current liabilities four have been addressed related to the asset issues explained above. The only outstanding line item is accounts payable.
A buyer’s primary concern is confirmation of the balances and assurance there isn’t a balance due to a vendor at year end that wasn’t posted to the books. In audits, accountants send out letters to vendors asking for confirmation of balances. This takes several weeks to complete. In a typical buyer’s situation, time is of the essence. How do you hunt for purchases made and not posted? There are different techniques.
A) Ask Employees – Most employees have no quarrel with a third party and are quite honest about what they see going on around them. Most of the payables are going to relate to the office operations or with a marina, the service department. Discussion about big ticket purchases are the most important. A $5 item isn’t going to make or break a deal. A $5,000 item creates a significant impact on the final dollar value.
B) Purchase Orders – Review purchase orders created during November and December. Any items not received; call the vendor and get the status. Small operations like White Diamond Marine most likely do not use purchase orders.
C) Review Bills – Look at the bills posted in January and February (subsequent months) to confirm receipt dates. This one simple step pretty much solves the problem.
D) Jobs Report – Many dealerships run service departments construction companies and use job costing. Basically all labor and parts are assigned to work orders. Review the work orders for discrepancies between revenue and costs. Essentially breaking down this department into respective individual job performance will identify any outstanding bills as the parts posted to a job prior to year end should also exist as a bill in the payables function.
After reviewing work orders you notice on one particular job completed in late November an electronic radio/radar system was installed on a small pusher boat. The customer paid but the costs for the equipment have yet to be posted. After discussing with the mechanic he confirms the receipt of the system and thinks it cost around $5,200. He identifies the vendor/supplier. After researching the office records, no bill could be found. A call is made to the supplier. The supplier apologizes but the bill has not been sent. It turns out the sales representative was injured in a car accident and is not due back for another week. The clerk was kind enough to identify that those systems are at least $6,000 and some are upwards of $7,200.
In this case revenue and labor costs are on the books but not the part. An entry is needed estimating the cost at $6,000 for this supplier. This debits cost of sales and reduces EBITDA.
Balance Sheet – Long-Term Debt
The most common error with long-term debt is assignment of the interest payment debit to the note account on the balance sheet or on the flip side, the principle portion debit that should reduce the debt balance is posted to the interest account on the profit and loss statement. Since interest is excluded in the calculation for EBITDA, any error made in reconciling entries for the debt payments has zero effect on EBITDA.
Summation – EBITDA
There are no issues on the balance sheet that can affect EBITDA. However based on the discovery of the errors above a buyer should be alert to several factors that play in the price offer. See the article EBITDA – Drawbacks (the next article in the EBITDA series) for more analysis. For now, let’s calculate the final EBITDA value based on the results from above:
EBITDA Based on P&L Adjustments (1st article in this series) $139,289
Dartman A/R Adjustment (Discounted Value) (2,992)
Hancock A/R Adjustment (Family Member Value) (1,590)
Work in Process (Reams Contract) (2,488)
Legal (Reams Civil Suit) (4,000)
Smith Note (Double Posting to Revenue) (14,700)
Smith Note Discount (13,230)
Crane Accident (Insurance Deductible) (22,117)
Warranties (Transfer to Cost of Sales) (8,902)
Electronic Parts Supplier (Reserve for the Bill) (6,000)
EBITDA Adjusted for Balance Sheet Issues $63,270
The total difference is a staggering $76,019. If a multiplier of three is used, the value decreased by $228,000. If the EBITDA prior to balance sheet adjustments were used and a multiplier of three determined; the total value for White Diamond Marine Inc. is approximately $418,000. Adjusted for the balance sheet items and again with a three multiplier (there is a justifiable argument that the multiplier should decrease associated with the balance sheet issues) it is now worth approximately $190,000.
The value is adjusting EBITDA for balance sheet issues plays a significant role in assessing the value of a small business to a realistic value.
The next article in this series explains the drawbacks related to using EBITDA in small business valuation. It also illustrates better alternative valuation approaches. Act on Knowledge.