We continue the series begun in the last post based on my long-ago staff memo regarding “The ABZs of Solid Valuation Conclusions and Reports.” While I am speaking from the viewpoint of a business appraiser in this series, the information should be helpful to attorneys who deal in matters pertaining to valuation. To some, much of what we will address in this series will be considered to be obvious or too elementary to discuss. However, I have found that the most frequent and often embarrassing errors that occur in valuation reports are the result of obvious issues or elementary mistakes.
“Talking to the Numbers”
Bob Rogers was CFO of First Tennessee National Corporation (now First Horizon) in 1975 when I went to work there after “retiring” from the U.S. Army. My first assignment there was a training stint on Bob’s staff. In those days, we did financial analysis the old fashioned way – with electric adding machines (or a four function hand-held device), present value tables, and pencils on ruled accounting pads.
With training in finance and economics and with a certain interest and inclination, I thought I was a pretty good analyst to begin with. However, I learned that there was a great deal about financial analysis that I did not know. I would take a particular workup into Bob’s office. He’d look at it for a minute and then point to some portion of the analysis and say something like, “Something’s not right here.”
Invariably, he was correct and something was not right. After a number of such instances, I finally asked him how he was able to pinpoint analytical problems or inaccuracies so readily. He said something I’ve never forgotten. “Chris,” he said, “You’ve got to talk to the numbers until the numbers talk to you!”
It took a few months, but over time, he found fewer and fewer issues with my various analyses.
Get Command of the Numbers
In order to value a business, one needs to get command of the numbers and the business being valued. It is hard to know which comes first, but we begin here with the numbers. An understanding of its numbers can lead to a better understanding of a business.
Get command of the numbers. Create a financial statement spreadsheet analysis that enables you to focus on the historical performance of the company. Read your spreads to be sure that they make sense. If things seem out of line or unusual, verify to source documents or raise questions for answering in your management interviews.
- Begin with a financial spreadsheet analysis? Every valuation engagement at Mercer Capital begins with a detailed spreadsheet analysis, which we at Mercer Capital refer to as the “spreads” for a company as of a particular date. Recall what Bob Rogers said about the numbers “talking to you.” They won’t talk and you won’t hear unless they are organized in a fashion that facilitates analysis and understanding.
- Expand the spreads to include product, customer, location, or other relevant analysis. For larger and more complex businesses, it is often helpful to provide detailed analyses of product lines and the margins associated with key products. A listing of the top ten, twenty (or more) customers over several years is also instructive. A key supplier analysis may be appropriate, particularly if there are concentrations. In addition, location or regional analyses (such as of sales and profitability) may also be appropriate.
- “Read” the spreads. When I tell someone to “read” the spreads, I mean just that. Sit down and read them. Begin with the text to be sure that you understand the terminology being used. Check spelling and titles for correctness. Then, literally, read the numbers. Look for unusual patterns or numbers that seem out of line. Does the history show a cycle? If so, where are we in the cycle? Are there unusual shifts or jumps on the balance sheet? Where is the cash flow going? How is the business being financed? Is growth accelerating or decelerating? When the numbers “talk to you,” you can literally understand what kinds of things must have been going on to cause the numbers to be the way they are. Financial statements are nothing more than the quantification of economic activity. By reading the spreadsheet, it is possible to begin to understand at least a portion of that economic activity. Your questions of management should be guided by your review.
- Highlight questions raised from reading the spreads. When talking with analysts who work on files with me, I use the term “leave tracks” when you read the spreads or any document relating to a valuation or litigation engagement. If you “leave tracks” when reading documents, you make it easier for others working on the file to be sure that important information is considered. It is frustrating to miss important parts of an analysis because it was not appropriately highlighted by the first person seeing it. You can leave tracks with pen, pencil or highlighter. In today’s (almost) paperless world, the tracks can be digital. Regardless, leave tracks.
- Are there any apparent discrepancies in the numbers that cry out for resolution? Sometimes there are real or apparent discrepancies in the numbers, either from year-to-year, or even within a given year. These discrepancies more often occur when the source documents are internal compilations or tax returns, rather than audits. But discrepancies and inconsistencies can also creep into audited financial statements. Watch out for them.
- How can you know if something is wrong with the numbers? Sometimes you can’t. But you can often tell, by the very nature of the numerical relationships indicated in the historical spreadsheet, that certain things might be wrong or, for that matter, right, and then pursue those matters with management. When I worked for Bob Rogers, we did all analyses on ruled accounting paper. I worked up many sets of analyses for Bob and would take them into his office. He would take a minute or a few minutes and then point to a section of the analysis and tell me there was a problem there. He was most often right and, until I caught on, I wondered how he could find the problem area(s) so quickly.
- Read the audits. Too often, business appraisers look at audited financial statements only as a source of the basic income statement and balance sheet numbers necessary to prepare of an abbreviated historical analysis. The company’s accountants spend a lot of time in preparing, and clients spend lots of money in getting, audits. Read them – including all the footnotes. A good financial spreadsheet analysis will reflect a significant portion of the detailed information found in the footnotes of audited financial statements.
- Highlight questions raised by the audits. It is critical to read the audits carefully and, with no apology for repetition, leave tracks. It is highly unusual, but over the years, we have found a number of mistakes in completed audits that, if not investigated, could have significantly impacted a valuation analysis. While mistakes are not usual in audits, it is common to find key valuation information relating to debt and financing terms, accounting treatments, transactions in a company’s equity, identification of non-cash items of significance, unusual expenses, and much more, including information about related-party transactions. The point is to read the audits carefully and highlight areas for further investigation. This means that you (or a competent associate) should read the historical audits, as well as the most current one.
- Identify potential normalizing adjustments. Often, it is appropriate in the valuation process to adjust a company’s income statement or balance sheet for unusual or non-recurring events. It is further necessary in appraisals to identify items of discretionary expense or income that impact reported earnings for potential adjustment. These items are identified beginning with the reading of the spreads noted above and continuing with the reading of the audits. Remember this “obvious” point. When an income statement adjustment is identified, there may be a corresponding balance sheet adjustment, and vice-versa.
- Read the subject company’s website. There is no excuse for not reading a company’s website and incorporating appropriate information in your analysis. By reading the company’s website you will accomplish at least three things: 1) you will identify potential questions to ask management; 2) you will find answers to some of your questions already addressed; and 3) you will avoid the embarrassment of being asked this question, “Didn’t you look at our website?”
The purpose of Items 1-10 above are to identify items and issues for discussion with management in the process of a valuation engagement. If an appraiser has “left tracks,” the likelihood of missing key issues or information is minimized.
Attorneys who are not familiar with the valuation process can learn a great deal by understanding some of the basics that should be baked into every valuation (or damages or valuation-related litigation) engagement. Attorneys with experience with business valuation should also find the road map outlined above to be helpful.
While this qualitative discussion of financial analysis may seem basic or obvious, it is most often the basic and obvious stuff that causes problems when appraisers fail to “get command of the numbers.”
May you all be well until the next time,
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