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Monday, November 16, 2015

Limitations of Financial Statements and Sales Pass the $10,000 Mark Last Week

In my last several posts, I attempted to shed some light on what each of the basic financial statements mean as well as explaining what lenders and investors look for when they are reviewing your financial statements.

Today I want to talk a little bit about the limitations of traditional financial statements. To talk a little about what they don't tell you.

What General Purpose Financial Statements Do Not Tell You

1. The total value of the business at any given point in time.
2. Whether the business will continue to perform as it has.
3. Whether the business can survive and grow in the next 10 years, 5 years or 1 year.

General purpose financial statements are based on a historical reporting model. They tell you what the business paid for the assets that it owns, what profits it made and what its obligations are. But they won't directly give you any indication of how the business will perform in the future. In  addition to external environmental factors which are outside the control of the business and cannot be reliably predicted, the future performance is very heavily dependent on the strategic operating decisions implemented and executed by management. The general assumption a reader might make is that management will continue to operate the business in the way that it always has. However, this may not be the case, and very likely is not the case, and current disclosure standards do not require management to disclose major changes in its strategic operating decisions. The only exception to this is where management decides to discontinue a segment of the business and here special disclosures for "discontinued operations" are required.

The value of a business is often completely and dramatically different from what appears on its balance sheet. This is especially the case for businesses that have large real estate holdings that it has held for a long time. In addition, many manufacturing businesses may have specialized equipment that if properly maintained is worth just as much used today as it was when the business bought it, even though it may be fully depreciated down to zero on the financial statements. Conversely a software development business, which may have capitalized expenses of developing its products as an asset on the balance sheet may find that there is no external marketable asset.

Business valuation is a very specialized and complicated area which has its own certified professionals who practice it. As a general rule of thumb the minimum value for a business being discontinued and broken up is the fair market value of each of its individual assets, less its liabilities. However, a business that is being sold as a going-concern, that is a business that will continue to operate is usually valued at a multiple of its average normalized earnings over a period of time. The term normalized simply means that any transactions that do not reflect normal market conditions have been adjusted to reflect market conditions or removed entirely. Another possibility is that missing transactions are added. For example, take a business that is operated by its owner who does not take a salary. Well, if this business were to be sold, someone would have to be hired to operate it and that person would have to be paid a market salary. Therefore in evaluating that business, you would have to consider not the profits shown on the financial statements, but what the profit would have been if you had to hire and pay someone to run it, since that is the reality that will exist after it has been sold. Another example of normalization comes about where the owners have taken unusually large bonuses out of the business in past years. These bonuses have the effect of artificially depressing profits, which in reality are much higher. Thus in evaluating a business like that, you would add the bonuses back to the net income in determining the average earnings.

The multiple to be applied to annual average earnings is what business valuators are paid to determine. A lot of factors go into it, some of which are specific to the industry, some of which are specific to the point in its life cycle the business is at, and still others are specific to the management team. A good general rule of thumb though for many business is a multiple between 3 times and 5 times annual earnings.

So in a nutshell, the financial statements will tell you whether a business was solvent at year end, whether it performed profitably and generated sufficient cash flows to sustain the business during the period, while giving some clues as to whether it is adequately investing in its future growth. The past, in the absence of more detailed information, is usually the best predictor of the future, but what you really need to look at if you want to know how a business is expected to perform in the future is a set of projections.

So that concludes my discussion of financial statements.

On another note, I am very pleased to report that my total sales since July 23 are now over $10,000. So that is now an average of $2,500 a month. In reality though more than half of that total is this month alone, and today is the 16th. So my sales are growing daily as I list more material and reach more collectors with social media. I launched my Facebook page last week "Pristine Canadian and British West African Stamps and so far, I have managed to obtain over 200 likes in just over 2 weeks. Not bad! The link to my page is below, if you want to check it out: