Free Cash Flow and Financial Ratio Quiz

Posted by on Jun 10, 2013 in Blog, Featured, Finance | 0 comments

This is a selection of True/False questions from a corporate finance course I took.  The questions are designed to be tricky, so read them carefully.  If you dont recognize certain terms, use this as a good opportunity to learn what they mean and how they can be used.  I have found Investopedia.com to be a good reference for this.  You might want to start with what ‘free cash flow’ is.  In future articles we will try to explain some of the answers and how these ratios are important to your company and general investing.

1. (T/F) An increase in ‘accounts receivable days outstanding’ will reduce free cash flow to the firm (FCFF).

2. (T/F) Reducing debt balances will decrease free cash flow to Equity (FCFE), all else equal.

3. (T/F) An increase in dividends paid will reduce free cash flow to the firm, all else equal.

4. (T/F) An increase in ‘accounts payable days’ will reduce the length of the ‘cash cycle’.

5. (T/F) An increase in interest expense will reduce the Return on Invested Capital.

6. (T/F) Comparing two firms with identical operating performance and size, the company with the higher debt ratio will experience greater variability in its Return on Equity, all else equal.

7. (T/F) Holding other factor constant, if a company increases its accounts payable balances and uses the cash to repurchase its own stock, the Return on Invested Capital will improve.

8. (T/F) The Return on Assets is unaffected by a company’s financing choice of debt versus equity.

9. (T/F) If two companies have the same level of current assets and current liabilities, the Quick Ratio will identify the company with more inventory as having lower liquidity risk (greater liquidity).

10. (T/F) A problem with using net income as a performance measure is that it is likely to lead to over-investment.

Answers: (1. T, 2. T, 3. F, 4. T, 5. F, 6. T, 7. T, 8. F, 9. F, 10. T)

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Business #11 – Art of the Appraisal

Posted by on May 31, 2013 in Blog, Featured, Finance | 0 comments

Business #11 came to us in a roundabout way.  We were advertising for drafting employees to meet the needs of our cell tower engineering customers.  A young lady came in to apply for the position.  We asked her why she was leaving her existing job and she said her employer was retiring.  We took that information and called the owner to find out about his business.  Sure enough, he was selling his business.    He was old, tired and ready to move on.

I contacted the business broker and we started in on the negotiations.  The first thing I received was a copy of the appraisal, which the owner paid a lot of money for.  Historic income statements showed declining sales:  2001, $1,119,655; 2002, $716,131; 2003, $439,599.

The appraiser then developed a risk factor model:

Build-Up Model, Risk Factors:

Risk-Free Rate                                     3.97%

Market Equity Risk Premium           6.92%

Small Business Risk Premium         20.00%

Total Discount Rate                       30.89%

The appraiser then capitalized the earnings with a weighted average:

Capitalization of Earnings            Normalized      Weighting        Weighted

                                                            Earnings           Factor                Earnings

Fiscal 2001                                             401,135                  1.0                  401,135

Fiscal 2002                                             239,774                  2.0                  479,548

Fiscal 2003                                             80,132                    3.0                 240,396

Sum of Weighted Earnings                                                                          1,121,079

Divide this by Sum of Weighting Factors                                                              6.0

Weighted Average Earnings                                                                        186,847

Divided by Historic Capitalization Rate                                                              30.89%

Total Equity Value                                                                                           604,877

It is important to note that business appraisals are part art and part science.  There are a lot of assumptions to be made and the combination of those assumptions can change the value wildly.  In this case, the appraiser weighted the last 3 years of earnings, giving more recent years a higher weight.  This is a common method, but past performance does not predict the future.  If you follow the trend line, the sales will hit zero in a matter of a couple years.  Stating that the company will generate free cash flow of $186,847 in perpetuity is wishful thinking at best.  The new owner needs to pull the business out of a nose dive, which could cost even more capital.  For this reason, its important to appraise a business in at least a few different ways to get a good idea of what’s at stake.  We plan to cover some of these ways in future articles.

With an appraisal in hand, the owner opened negotiations with a sales price of $600,000.  We told the broker we were not interested at all at that price.  His expensive appraisal was only looking at past results and did not forecast the most likely scenario going forward, which was a continuation of 2003 results.  We just stayed in touch while the broker tried to find other buyers.  The seller and broker came to the realization if they wanted to sell his business he needed to lower the price to a reasonable number.  We entered serious negotiations and the business sold for 25% of the appraised value.  I negotiated my usual 50% down, 50% financed over 5 years.

We were able to stream-line the operation and this became a very profitable branch office, even at historically low volumes.

Keys To Success

  • Business appraisals are just assumptions, if yours are different, don’t buy
  • Do not be put off by the initial asking price
  • Be observant and look for opportunities everywhere

 

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