Manufacturing and Distribution Group Newsletter – Fall 2019
Mark A. Thomson, Kenneth Tornheim
Valuing Your Business
MARK THOMSON, CPA
Retirement. Loan applications. Shareholder buyouts. Divorce. Understanding what improvements drive the most value. There are many reasons to value your business. But, manufacturers cannot necessarily find the answer on the face of their balance sheet — or rely on industry rules of thumb. Instead, you will need to hire a business valuation professional to get a reliable estimate.
Valuators bring value
If you Google “valuation rules of thumb for manufacturers,” a wide range of results will appear. A common valuation rule of thumb for manufacturers is four to five times earnings before interest, taxes, depreciation and amortization (EBITDA). But, many businesses sell for more (or less) than this range depending on the buyer, the industry and the performance of the company.
This oversimplified formula can serve as a useful sanity check for a purchase offer. However, you should not rely on it alone when selling your business, because it is arguably the most important business decision you will ever face.
Tangible assets — such as receivables, inventory and equipment — are important to manufacturers. However, in a technology-driven, relationship-based market, intangibles — such as customer lists, patents, assembled workforce and goodwill — also contribute significant value. Professional valuators generally look beyond the cost approach and, instead, rely on market or income-based methods when valuing businesses in the manufacturing sector.
Let the market decide
Under the market approach, sales of comparable public stocks or private companies may be used to value your business. Finding comparables can be tricky, however. Many small, private manufacturers tend to be “pure players,” whereas public companies tend to be conglomerates, making meaningful public stock comparisons difficult.
When researching transaction databases, it is essential to filter deals using relevant criteria, such as industrial classification codes, size and location. Adjustments may be required to account for differences in financial performance and to arrive at a cash-equivalent value, if comparable transactions include noncash terms and future payouts, such as earn-outs or installment payments.
Cash is king
Under the income approach, expected future cash flows can be converted to present value to determine how much investors will pay for a business interest. Reported earnings may need to be adjusted for a variety of items, such as accelerated depreciation rates, market-rate rents and discretionary spending, such as below-market owners’ compensation or non-essential travel expenses. This is almost always the case when working with privately owned companies. (See “How Valuators Adjust a Financial Picture.”)
A key ingredient under the income approach is the discount rate used to convert future cash flows to their net present value. Discount rates vary depending on an investment’s perceived risk in the marketplace.
How much is your business worth today? You probably have a rough estimate in your head, but most owners have limited experience in the M&A market. A valuation professional can provide an objective answer that you can take to the bank ― or a courtroom and beyond. Even more important is using a current valuation to identify what changes you should make in order to increase value for the time when you are ready to sell.
Sidebar: How valuators adjust a financial picture
Oftentimes, professional valuators tweak financial statements before using them to appraise a business. Three common types of adjustments are:
These align the company’s financial statements with GAAP or industry standards. For example, if the company uses the cash (versus the accrual) accounting method, balance sheet items might be adjusted.
- Non-Recurring and Non-Operating Items
Historical financial results are not as relevant to investors as future potential. Valuators might eliminate discontinued operations and one-time events unless they are expected to recur.
- Discretionary Spending
These adjustments are not appropriate for all businesses. For instance, above- or below-market owners’ compensation may be adjusted — but only if the owner will be leaving.
For more information, contact Mark Thomson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing & Distribution Group.
Are You Ready for the New Lease Accounting Rules?
KENNETH TORNHEIM, CPA, CFE
New lease accounting rules will move operating leases onto the balance sheet. Public companies started using Accounting Standards Update No. 2016-02, Leases, at the beginning of this year. Private companies must apply the updated guidance for fiscal years beginning after December 15, 2020 (2021 for calendar-year companies), and for interim periods within fiscal years beginning after December 15, 2021.
The deadlines for private companies include a one-year deferral. This summer, the Financial Accounting Standards Board (FASB) unanimously agreed that a delay in the implementation deadlines would be beneficial for private companies. Many businesses told the FASB that they were not ready to implement the lease standard, because they were struggling with resource constraints and insufficient technology expertise in setting up internal systems after having to adopt revenue rules.
Based on feedback from public companies, implementing the updated lease standard can be expensive and time-consuming. So, even with a one-year reprieve, private manufacturing companies should start the implementation process as soon as possible.
Lease accounting 101
Under current U.S. Generally Accepted Accounting Principles (GAAP), private companies classify leases two ways.
- Capital (or Finance) Leases
Under these types of financing arrangements, ownership of the underlying asset is transferred to the lessee at the end of the term. These are reported on the lessee’s balance sheet.
- Operating Leases
These off-balance-sheet arrangements provide rights to use the underlying asset during the lease term. They must be disclosed in the financial statement footnotes.
The updated guidance requires leases with terms of at least one year to be reported on the balance sheet. The lessee records a “right of use” asset — generally equal to the minimum payments under the lease, discounted to present value — as well as a liability reflecting its obligation to make those payments. The new rules maintain the distinction between operating leases and capital leases, which affects expensing of lease-related costs.
A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time. The term “control” refers to the right to direct the use of the asset and to obtain substantially all resulting economic benefits.
A major challenge under the updated rules is identifying “embedded” leases in other types of contracts, including certain service contracts and contract manufacturing arrangements. For example, a transportation contract may provide exclusive rights to, and control over, a specific vehicle or fleet of vehicles. Under the updated guidance, companies will need to separate lease and non-lease components of these contracts and provide detailed disclosures.
Implications for manufacturers
Do you have significant operating leases for facilities, warehouses, equipment, vehicles and other assets? If so, evaluate the impact of the new lease accounting rules. When they take effect, you will see an immediate increase in assets and liabilities on your balance sheet. This can make your company appear more leveraged than before, affecting the way investors and lenders view your financials.
Moving leases to your balance sheet may also cause technical violations of loan covenants that limit your debt or require you to maintain certain debt ratios. It is important to discuss the effects of the new accounting rules with your lenders to minimize surprises when you deliver your financial statements and, if appropriate, to negotiate amended loan covenants.
Before the new lease accounting rules take effect, review your contracts to determine which ones are leases — or contain leases. Then evaluate your accounting systems, processes and internal controls to ensure that you are prepared to track and record the necessary data for both reporting and disclosure purposes.
The new rules expand the types of information you will need to gather and the calculations needed to determine lease values and expenses. To simplify matters, you may want to explore lease management software that automates the process.
Most private manufacturers expect to spend significant time and effort to comply with the new lease accounting rules. Contact an accounting professional for implementation guidance.
For more information, contact Ken Tornheim at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.
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