Financial Statements and Business Valuation - Case Study Example

FINANCIAL MENTS AND BUSINESS VALUATION By: + Having a clear understanding of the business financial outlook is critical to every business owner for a couple of reasons. Business owners hire accountants to conduct a financial analysis of a past year or even the value of assets a company might be having. Similarly, a company needs to understand the value of its liabilities in comparison to its assets. A financial statement comprises of three major reports including the balance sheet, cash-flow statement and income statement. Without these statements, it might be impossible for a business owner to understand the exact look of the business. Further, it may be difficult to access credit facilities from funding institutions because there is no evidence on the business performance. Besides illustrating two of these statements, this paper uses Wal-Mart’s statements to highlight the strengths and limitations of financial companies when it comes to valuation. Balance sheet A balance sheet details a company’s information about assets, liabilities and shareholders’ equity. In the case of assets, there are two categories: current and fixed assets. Current assets refer to either cash or holdings whose conversion to cash can take a maximum period of one year. For instance, investments, inventory, prepaid expenses, patents and trademarks are classified as current assets. Fixed assets refer to the physical assets like properties, land to name but a few (US Securities and Exchange commission, 2015). Liabilities in a business are the money a company’s debt to others in terms of loans, obligations and debt. For instance, operation cost, salary to employees, taxes, money owed to suppliers and even rents all are termed as liabilities. When it comes to capital, often called shareholders’ equity, this is the projected money remaining if the business were to sell its assets and clear its liabilities. Income statement Often called Profit &Loss (P&L) statement or Revenue & Expense report, this report is mostly prepared after a period of one year, and highlights the cost of revenues. That is to say, it presents the amount of money that was spent to have a particular earning (Penman, 2009). At the bottom, an income statement gives the net loss or profit. Again, it sometimes reports its earnings in terms of Earning per Share (EPS), which simply shows the amount a shareholder would earn. Cash flow statement This is one of the most critical documents of a company as it gives a picture of how a company’s money comes in and how it leaves. It slightly varies with the income statement in the sense that a cash flow statement gives a clear picture of the cash generated unlike the former that tells more of the profit or loss a firm witnessed. Strengths and Limitations of income statements Strengths Without an income statement, it would not be possible to know if a firm is making loss or profit as it highlights all these. Even though financial statements do not accurately provide the much-needed information, they enable valuers get the estimation. Merger and acquisition is a trend that has become quite common in the 21stcentury where different firms are merging to form one business entity. Others tend to acquire the entire business, and proceed on as the sole owner, an occurrence that is catalyzed by a number of things. Without a financial statement, it would prove hard for the negotiating parties to do business. Whenever companies want get involved in a merger or acquisition deals, the information about each other’s finances play a pivotal role in determining the value (Mobolurin, 2007). In addition to the above, financial statements, like the balance sheet will make it easier for the investors to understand if the business is worth investing in (Prakash, n.d.). Usually, a balance sheet highlights the very state of a business, and its ability to progress and handle credit facilities. Again, a balance sheet has liquidity and current ratio which could be used to project the future, though not accurate. Most valuation tend to focus first on balance sheet, and in the case of mergers, this statement is important. For instance, if Wal-mart were to be another company’s target the latter would be required to spend a considerable amount of money because the former’s cash flow statements seems stable. The figure below shows the Wal-mart’s income statement together with P/E ratio Figure 1.0 Period Ending: 1/31/2014 1/31/2013 1/31/2012 1/31/2011 Total Revenue $476,294,000 $468,651,000 $446,509,000 $421,849,000 Cost of Revenue $358,069,000 $352,297,000 $334,993,000 $314,946,000 Gross Profit $118,225,000 $116,354,000 $111,516,000 $106,903,000 Operating Expenses Research and Development $0 $0 $0 $0 Sales, General and Admin. $91,353,000 $88,629,000 $85,025,000 $81,361,000 Non-Recurring Items $0 $0 $0 $0 Other Operating Items $0 $0 $0 $0 Operating Income $26,872,000 $27,725,000 $26,491,000 $25,542,000 Addl income/expense items $119,000 $186,000 $161,000 $201,000 Earnings Before Interest and Tax $26,991,000 $27,911,000 $26,652,000 $25,743,000 Interest Expense $2,335,000 $2,249,000 $2,320,000 $2,205,000 Earnings Before Tax $24,656,000 $25,662,000 $24,332,000 $23,538,000 Income Tax $8,105,000 $7,958,000 $7,924,000 $7,579,000 Minority Interest ($673,000) ($757,000) ($688,000) ($604,000) Equity Earnings/Loss Unconsolidated Subsidiary $0 $0 $0 $0 Net Income-Cont. Operations $16,551,000 $17,704,000 $16,408,000 $15,959,000 Net Income $16,022,000 $16,999,000 $15,699,000 $16,389,000 Net Income Applicable to Common Shareholders $16,022,000 $16,999,000 $15,699,000 $16,389,000 Strength of the financial statements is that business owners can use the information to plan for both short term and long-term goals. For instance, if someone was to buy Wal-mart there is a trend that shows exponential increase on the side of current stock. For the four year period, the current assets have appreciated meaning that the value keeps increasing. If valuation was needed, both the buyer and the seller would have an understanding of the strategy to use to capitalize on the same. In other words, the buyer would know that the assets are valuable, and that they will increase; the seller would have an advantage in terms of pricing. Limitations All the above statements have their limitations, many of which are a result of usage of past information, and failing to address or project future outcomes. A case in point is the cash flow statement which, just like the balance sheet and the income statements is prepared using the past information. As a result, it inadequately tackles the issue of the future state of the cash flows, hence leaving both the shareholder and business owners unprepared. Additionally, cash flow statements normally ignore the very basic accounting concept of accrual (Yongkui, 2013). In accounting, Accrual concept refers to revenues and expenses whose recording appear the very minute they occur irrespective of whether cash payments are involved. While an income statement does indeed show the current outlook of a company, it has a few weaknesses. According to Davis et al (2004), an income statement has two major weaknesses: Accounting data and Accounting methods. A cash flow proves a business can pay bills, but fails to relate the cash with the business activities. Additionally, if fails to highlight some of the most likely factors to affect the business in its quest for growth. Because of being limited to accounting data, market expansion, products that could be in pipeline or even competitive advantages are seldom included in the analysis At times, the reported assets, equity and even liabilities are not proportionately related to the financial position of the organization. According to Davis et al (2004) the reason that causes this to happen is that some of the estimated cost of the said component may not be accurate because of the price fluctuation in the case of assets. Liabilities may increase in the case of higher salary demands by workers. Therefore, when it comes to valuation, there is a likelihood of one party being shortchanged. For instance, Wal-Mart’s current assets as at 31st Jan 2011 stood at $52, 012, 000 and a year later at $54, 975,000 meaning there was an increase of close to $2 million. On the other hand, the net come for the same period was $16, 389,000 and $15, 389,000. In this instance, while the current assets were more than the net income, the former does not outline the methodology used in reaching that figure. For someone in need of valuing Wal-Mart the current assets’ estimates may look enticing, but the situation may be different in reality. Subsequently, in the case of acquisition, the buyer may end up paying more than the precise worth of the firm. The figure below represents a balance sheet for Wal-Mart between 2011 and 2014 Figure 1.2 Period Ending: 1/31/2014 1/31/2013 1/31/2012 1/31/2011 Current Assets Cash and Cash Equivalents $7,281,000 $7,781,000 $6,550,000 $7,395,000 Short-Term Investments $0 $0 $0 $0 Net Receivables $6,677,000 $6,768,000 $5,937,000 $5,089,000 Inventory $44,858,000 $43,803,000 $40,714,000 $36,437,000 Other Current Assets $2,369,000 $1,588,000 $1,774,000 $3,091,000 Total Current Assets $61,185,000 $59,940,000 $54,975,000 $52,012,000 Long-Term Assets Long-Term Investments $0 $0 $0 $0 Fixed Assets $117,907,000 $116,681,000 $112,324,000 $107,878,000 Goodwill $19,510,000 $20,497,000 $20,651,000 $16,763,000 Intangible Assets $0 $0 $0 $0 Other Assets $6,149,000 $5,987,000 $5,456,000 $4,129,000 Deferred Asset Charges $0 $0 $0 $0 Total Assets $204,751,000 $203,105,000 $193,406,000 $180,782,000 Current Liabilities Accounts Payable $57,174,000 $59,099,000 $55,952,000 $52,534,000 Short-Term Debt / Current Portion of Long-Term Debt $12,082,000 $12,719,000 $6,348,000 $6,022,000 Other Current Liabilities $89,000 $0 $0 $47,000 Total Current Liabilities $69,345,000 $71,818,000 $62,300,000 $58,603,000 Long-Term Debt $44,559,000 $41,417,000 $47,079,000 $43,842,000 Other Liabilities $0 $0 $0 $0 Deferred Liability Charges $8,017,000 $7,613,000 $7,862,000 $6,682,000 Misc. Stocks $1,491,000 $519,000 $404,000 $408,000 Minority Interest $5,084,000 $5,395,000 $4,446,000 $2,705,000 Total Liabilities $128,496,000 $126,762,000 $122,091,000 $112,240,000 Stock Holders Equity Common Stocks $323,000 $332,000 $342,000 $352,000 Capital Surplus $2,362,000 $3,620,000 $3,692,000 $3,577,000 Retained Earnings $76,566,000 $72,978,000 $68,691,000 $63,967,000 Treasury Stock $0 $0 $0 $0 Other Equity ($2,996,000) ($587,000) ($1,410,000) $646,000 Total Equity $76,255,000 $76,343,000 $71,315,000 $68,542,000 Total Liabilities & Equity $204,751,000 $203,105,000 $193,406,000 $180,782,000 Source (Nasdaq) Contingent liabilities are never included in any of the statements, and this could be detrimental to the buyers in case a company is up for sale. These liabilities that a business owner may have pledged to act on behalf of another, for instance, co-guaranteeing a loan for another person. Also, Ratio analysis also tends to omit some very important intangible assets such as skills and culture, relationships and brand. As earlier noted, these are often hard to account for meaning valuation may omit, undervalue or overvalue it. Either way, the fact that these cannot have the precise cost means valuation may be erroneous. Evidently, in the two financial statements of Wal-mart, neither addresses these assets, thus confirming these assertions. Asset inflation cannot be overlooked as another likely occurrence on the world of business, especially when valuation is a requirement. In some case, though rare, assets do depreciate because of the tightness of monetary retrain which subsequently leads to low spending. When this occurrence is unavoidable, the once highly-valued asset may have a significance drop in price which would result in the current holder incurring loss. Sadly, these projections will not be available on the any of the documents mainly because it is not easy to predict the financial sector. Consequently, valuation of a business then fails to factor in these likely outcomes because in the first place, the financial statements are less-helpful in this regard. Conclusion To sum it up, the financial documents often used in the business are pivotal to the entity, and ought to be kept well always. Moreover, the documents greatly help in understanding the direction and the trend a business is creating. For various reasons such acquisitions and mergers, liquidation, dissolution and equity valuation is needed. However, valuation of a business can hardly take place without these documents, and it is for that reason that a business keeps undertaking this exercise. Decision-making in business will greatly be dependent on these financial statements, thus ought to be available. Nonetheless, in valuing a business, these statements fail to provide all the information. Additionally, the projections and estimations are not always accurate, and this could be detrimental to either side in case of a business sale. Bibliography Davis, J., Wicas, N. and Kinniry, F. (2004). The Strengths and Weaknesses of Various Financial Simulation Methods. The Journal of Wealth Management, 6(4), pp.33-36. Mobolurin, O. (2007). Imperatives of mergers and acquisitions. Securities Market Journal, 10(1). Prakash, R. (n.d.). Macroeconomic Factors and Financial Statements: Asset Writedowns During Recessions. SSRN Journal. Penman, S. (2009). Accounting for Intangible Assets: There is also an Income Statement. Abacus, 45(3), pp.358-359. Yongkui, Z. (2013). Limitations of Financial Statements and Disclosure of Core Information. Journal of Applied Sciences, 13(13), pp.2505-2510. US Securities and Exchange commission, (2015). SEC.gov | Beginners Guide to Financial Statement. [online] Available at: http://www.sec.gov/investor/pubs/begfinstmtguide.htm [Accessed 26 Mar. 2015]. Read More