Business valuations begin with the most readily available source of information regarding the venture, its financial statements. Financial statements that are used for valuation purposes should be audited by a CPA, ensuring that the accounting procedures followed by the firm being evaluated are proper. When examining financial statements for the purpose of valuation of a small private venture it is important to take certain considerations into account. Many evaluation methods that are commonly used require the valuer to adjust the income statement and balance sheet for the effects of common small firm accounting practices.
Similarly, there are special considerations in separating a business owner’s choices and preferences from the financial data. The financial statements should be scrutinized and analyzed for the effects of the choices and preferences of the entrepreneur. Then appropriate adjustments should be made. The intermingling of the owner’s assets and those of the business should be examined explicitly and accounted for (Peterson, Plenborg & Scholer, 2006). Additionally, inventory and assets, wages, administrative expenses, and owner’s compensation need to be studied (Lewis, 1988).
A valuer must consider the type of inventory accounting that the business has used, last-in-first-out (LIFO) or first-in-first-out (FIFO). If LIFO was used, the inventory replacement value may be more than is reflected on the financial statements. If FIFO was used, the net income of the business may be overstated, reflecting a cost of goods sold that does not correspond to current market prices. Assets need to be appraised for their age and condition, and compared to the values conveyed by the balance sheets. Considerations such as depreciation methods, remaining useful life, and replacement costs should be noted (Lewis, 1988).
Wages should be researched to see if they accurately reflect the value of the services provided by employees. Employees may not be receiving wages commensurate with their contributions, so that raises are required to minimize personnel turnover. Conversely, family members may occupy “phantom positions” as a means for the owner to distribute wealth (Peterson, Plenborg, & Scholer, 2006). Administrative expenses may be excessive if the business is retaining unneeded services. On the other hand, vital services may have been recently cut, to increase short-term profits, which are not sustainable.
Finally, the owner’s compensation should be evaluated closely. Owner’s compensation may need to be adjusted upward if the owner is not receiving a salary that is commensurate with the services provided. The opposite may be true as well, with the owner extracting his return on capital and business profits through an inflated salary. Benefits that the owner receives should also be accounted for, such as cars used by the owner that belong to the business, travel expenses, and business promotion and entertainment expenses (Siegel & Gavron, 1994). All of these decisions and adjustments are judgment-based and require a justifiable reasoning to uphold the assumptions (Harrison, 2003).
After required adjustments are made to the financial statements, the valuer may be able to draw a clearer picture of the true financial health of the firm. These initial adjustments are crucial to the valuation process and the appropriately adjusted financial statements become the basis for valuing the firm using the various methods available. Techniques used in these methods require comparison of the firm to industry averages, valuing the assets and liabilities of the firm themselves, and projecting the future of the firm after scrutinizing historical data. There are several general bases of valuation theories. These are asset-based theories, earnings based theories, and cash flow or income based theories (Pricer & Johnson, 1997)(Carland & White, 1980)(Jenkins, 2006). Each of the theories has its merits and can be useful in particular situations.
Many small businesses do not wish to pay significant appraisal fees, and so general rules of thumb have been developed. These rules of thumb consist of ranges that can be applied to key financial numbers, providing a quick and dirty method of indicating a firm’s value (Sliwoski, 1999). Business brokers with large databases of business transactions, which can be averaged to provide a very general indication, often generate these rules of thumb. As a whole, these methods are overly generalized and do not consider particular key elements of a firm. They vary from region to region and ignore important value indicators (Sliwoski, 1999). More accurate methods of firm valuation are readily available and can be applied in a fairly simple and straightforward manner.