The starting point for business valuation is by analysing an entity’s financial statements, but don’t forget to dig deeper, study qualitative factors and comparative information to piece together a complete picture.
By Abdul Razak Rahman
Financial statements provide vital information on an organisation’s financial health and are also commonly used as one of the key ingredients in determining a company’s worth.
According to Rajan Paramesran, Chief Rating Officer, Malaysian Credit Rating Berhad, speaking at the MIA MFRS Conference 2017, financial statements are important because they provide the building blocks for a host of financing decisions by various stakeholders such as management, investors, regulatory bodies, rating agencies and government agencies.
It goes without saying that integrity and trust in the financial statements are critical. “The faith in the integrity of the accountancy profession and the rigorous accounting processes lend credibility to the financial statements in terms of the required compliance with established standards and regulations, and transparency,” he said.
From the rating agencies’ perspective, its general framework on ratings combines quantitative and qualitative factors. In determining a company’s worth, business risks such as industry factors and competitive environment, financial risks such as operating performance and financial strength, and management risks and other qualitative factors such as strategy, expertise and governance are assessed. In evaluating the financial risk, the common key ratios that are extracted from the financial statements include profitability ratios such as operating profit margin, and cash flow ratios such as interest cover and debt cover ratios. This initial assessment and analysis of the financial risk, which is premised on historical financials, will be used as a starting point to project future financial performance by including ratios such as debt-to-equity ratio, debt service cover ratio as well as sensitivity analysis on the cash flows. The financial statement however can misinform if corporations resort to non-compliance or fraudulent practices which include managing earnings flow, overstating the assets, understating or non-disclosure of off-balance sheet financing, and inadequate disclosures of relevant accounting principles.
The Importance of Business Valuation
Accurate valuations are fundamental to the quality of financial statements. “Valuation can be both science and art. Science because it relies on the historical financial data as the baseline, and art because in reality, it involves a lot of business judgement when looking forward,” remarked Aida Lim Abdullah, Managing Director and Founder of Corporate Stress Sdn Bhd. Furthermore, valuation is also very subjective and its perspective differs between the buyer and the seller.
For valuation purposes, finance professionals rely extensively on financial statements and will focus on the balance sheet, income statement and cash flows. Net tangible assets are key in the balance sheet whereas for the income statement and cash flow the focus will be on the earnings’ quality and cash flow quality respectively.
Valuation using the conventional accounting approach which focuses on the balance sheet can be used as a baseline valuation since it is premised on historical information, she explained. A more suitable alternative is to look at valuation from the corporate finance perspective, which is forward-looking and puts greater emphasis on income statement and cash flow as well as market elements. With the emergence of technology companies and start-ups, the balance sheet landscape has also changed, ushering in a significant increase in intangibles. Valuation of intangibles is an art since there is no one prescribed method. For example, in arriving at the valuation of an infrastructure project company, one method is to rely upon the land value disclosed in the financial statements. Thereafter, the valuation will revolve around the forecast numbers and other qualitative factors such as SWOT analysis.
Looking Beyond Historical Numbers
However, the numbers that appear in financial statements do not give a complete picture as this is static information based on historical events, said Meor Amri Meor Ayob, CEO of Bond Pricing Agency Malaysia Sdn Bhd (BPA). BPA for example has net tangible assets (NTA) per share of only RM0.11 but substantial cash reserves. Although the NTA is not particularly impressive, the potential growth from its cash reserves is significant.
Therefore it is important to look deeper beyond the surface numbers in the financial statements. “It is important to understand the stories behind the balance sheet. Talk to the management to comprehend the underlying assumptions and numbers will come alive. Valuation is not about historical (numbers) but the value of the company in the future and the financial assets that are generated in the market. Management accounts are another source of financial data as these provide greater details on the financial health of an organisation,” advised Meor.
Valuing SMEs and Crossborder Companies
For the valuation of an unlisted entity or a small private company that has limited financial information, Aida suggested that the best approach is peer comparison, by identifying a similar company within the same industry and performing comparative analysis. The most practical approach is to use indicators such as the industry’s average price-earnings ratio as a benchmark, and apply that to the operating profit of the unlisted entity. Earnings aside, the cash flow position of a company is also crucial in valuing a company as it will determine its sustainability and going concern.
For cross-border comparison, Aida advised being mindful of the convergence level of the country’s accounting standards. Financial statements prepared in countries whose accounting practices deviate from the international standards would need to be discounted in arriving at the valuation. In some countries such as in the Middle East, financial statements are not publicly available and therefore comparative analysis using financial data is limited. In such instances, potential investors will perform valuation and comparison solely on qualitative factors such as market position and reference, quality of management, profile of customers and the development cycle of the organisation, clarified Meor. Other qualitative factors that can affect valuation are good corporate governance, responsible culture, integrity, strong corporate values, and the company’s mission and vision statement as evidenced in the strong valuation of Ben & Jerry’s, said Aida.