Financial Statement Analysis
Don’t Value A Business Without It

Business valuation may be required in a variety of legal contexts, and an accurate appraisal is essential for all of them. Valuation experts, however, can have a hard  time calculating accurate numbers if they aren’t permitted to analyze the subject company’s financial statements. You can make the process easier for them by doing what you can to facilitate access to these documents.

Starting with a good set of data

Merely accepting a company’s financial statements at face value can lead to seriously undervaluing or, more likely, overvaluing the business. Closely held businesses that aren’t legally required to have their financial statements audited are at particular risk for skewed results because their financial statements may never have been subjected to Generally Accepted Auditing Standards (GAAS). Valuators, however, typically insist that companies comply with Generally Accepted Accounting Principles (GAAP), at a minimum.Private businesses can pose another problem as well. Many fail to prepare formal financial statements, forcing the valuation expert to rely on income tax return data. This data may not comply with GAAP and, because it typically is calculated on the cash basis of accounting, the expert must convert it to the accrual basis to get a more accurate financial picture.What’s more, a closely held company’s financial data may be shaped to favor the owner’s interests. For example, an owner might take an artificially large salary to reap tax benefits or, conversely, a small salary to enhance the company’s earnings. Similarly, financial statements can reflect tax minimization strategies that produce misstatements related to assets, revenues and expenses, such as the improper expensing of fixed assets that should be capitalized. So that earnings may be analyzed accurately, valuation experts typically review a company’s financial statements going back several years. They then make normalizing adjustments, removing nonrecurring items (such as gains on the sale of a fixed asset) and adjusting expenses that a potential buyer wouldn’t likely incur (such as an owner’s golf club membership).Valuation experts often testify in court about their conclusions and methods. An expert who hasn’t analyzed the financial statements risks challenges to his or her credibility — or even impeachment.

Looking for suspicious trends

Experts begin valuing a business by reviewing its financial statements for unusual or suspicious trends and relationships. If anything turns up, the expert performs more intensive forensic accounting work, possibly including analysis of specific transactions, journal entries, work papers and the supporting documenting evidence. Note that this forensic examination goes well beyond a standard audit conducted under GAAS as well as standards of valuation. If the expert uncovers transactions that may themselves be deemed criminal activities, he or she may consider disengaging from the valuation.The expert will apply several different types of analysis, such as:

• Vertical, which allows the expert to compare data from a single year to uncover unusual patterns that may require adjustments,
• Horizontal, which serves the same goal but allows the expert to compare current data with data from previous years
• Financial ratio, which calculates ratios from current year data and compares those with previous years’ ratios for the subject company, comparable companies and the relevant industry.

To successfully apply financial ratio analysis, the valuation expert should have experience in the particular industry. And the expert must know GAAP and be able to recognize noncompliance with it. Noncompliance, in fact, is a large red flag and should prompt the expert to scour the statements with a more critical eye, including reviewing disclosures and footnotes.

Arriving at an accurate valuation

Experts must closely analyze financial statement data to reach a true, unbiased understanding of a company’s financial situation. Without the aid of a thorough expert, attorneys risk presenting a case that under- or overvalues a business.

Additional Reading: 

"Surviving The Latest IRS Challenge"

"Rocky Economy Alters The Valuation Landscape"

"What's Normal?  How Valuators Adjust Earnings To Reflect Market Value"

Tim McPoland	Ron Soluri, Sr.	Mike Ervin	Howard Rein	Tom Chiavatta	Dave Barrett
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