Practical examples: adjustments to statements

This article uses an online model to work through the adjustments we need to make to a firm’s financials in order to compensate for non-market related owner’s compensation, discretionary expenses, one-time losses/gains, periodic expenses and non-operating expenses.

This article links to the public model here:

(Note that this model will be updated over time as we introduce further concepts and get into the full DCF).

Let’s chat about a Machine Parts manufacturing business we’ll call ‘Wobbly Machinery’. The business is for sale, and you are considering buying it. John Smith is the owner, and he employs his attractive (but not very bright) daughter Angela. Our challenge today is to look at a couple of numbers to quickly establish a view on the actual profits that the business is generating and that it might generate going forward.

The first tool that we use to look at any numbers is what’s known as the CAGR (compound annual growth rate). CAGR allows us to quickly calculate the average growth rate for sales, cost of sales, expenses and net income over the period. Since humans are not very good at understanding patterns where the year-on-year swings can be quite wide, the average over the period allows us to quickly spot the trend. The CAGR formula is (End value/Start value)^(1/periods in between)-1.

Using this, firstly, we see that sales have grown from R1M in 2008 to R1.3M in 2012, a CAGR of over 7%. However Net Income has grown only 2% in the same time. The immediate cause seems to be expenses, which have grown 10% during the same period. With margins decreasing so quickly, is there a business here we’re interested in? Let’s look through the adjustments to get the real picture:

John Smith pays himself R225K per year, and he pays attractive Angela R52K to play solitaire all day. If you were to buy the business, you’d pay a manager to replace John Smith (if you don’t do this, be careful that you are not just buying yourself a job), and you’d fire Angela. So the question is what would you pay for the manager? Some research by skimming through the jobs advertised in the classifieds tells you that you’d pay R100K in 2012. So all we need to do is deflate this number by inflation (at 6%) over the years to understand what it would be worth in 2008 onwards.

These calculations are shown in rows 12-15. The principle in each is that to Net Income we add back the actual salary/compensation then subtract what we’d pay if we were running the business.

The next step is discretionary expenditure, and here we see that Wobbly Machinery is paying a regular donation to a charity run by Angelas’ live-in boyfriend. Given that the charity has nothing to do with the business, we can safely assume that we will stop this spend once the business is ours. So we add it back in row 16.

The financials show a R520K loss from discontinued operations. It seems that John supported Angela’s idea of building an online application for Machine Parts, but that this hasn’t worked and they’ve written it off. It turn’s out that the prior attempts by Angela to build a business or explore an idea are what make up most of the prior-year’s losses from discontinued operations too, and they can be safely added back to get closer to real profits. (Lest you think this is unrealistic, this exact pattern is common in many family owned-businesses we’ve seen).

Lastly, we look at the lease and see that it comes up for renewal in 18 months, and quickly determine that if the business grows we’ll need to move. It looks like the business needs to move every 5 years or so, so we take the estimated cost of moving (using the real cost incurred in 2009) and split it across each of the five years to get a better picture of once-off/non-operational costs.

The result then is that we have Adjusted Net Income before tax (in line 21) that are far higher than those reported. In fact, they are nearer 7% on average than the 2% reported. Net income is nearly 4x higher than reported when we’ve adjusted carefully.

The last thing we should do is put some reliability estimate behind the numbers. Since more recent results reflect the future of the business more than results from 5 years ago, we need a weighting method. Accountants have a great method called ‘Sum of year’s digit’ to do just this, and its simple: you take the 5 years of statements (in this case) and add up the years to get 15 (1+2+3+4+5=15). Then you weight the profit margin from each year as 1/15, 2/15, 3/15, 4/15, and 5/15 accordingly and add them up. The results are shown in row 26, which when summed gives us a profit margin of 11.41%.

Now at last we have a starting estimate of reliable profit margins in the business that we can use to calculate its value going forward, which is where we’ll start next week.

This article originally appeared in Finweek.

  • Kevin Scott

    Great piece – very practical.

    • Gareth Ochse

      Thanks Kevin. Hope you enjoy the other posts…