July 25, 2011

Valuation of business on owner's balance sheet

Lender question:

For privately held companies, how should lenders consider valuation of the business by owners on their personal balance sheets? These dollars clearly will impact level of leverage, both on a personal basis as well as global.

Linda says:

The amount an individual reports on their personal balance sheet for their owner share in a business can be anything from the actual share of business capital per GAAP statements to a ‘fair market value’ estimate based on their own sense of what it is worth.

You know how we discount heavily what a person puts down for the ‘value’ of their home? And even more so what they may put for the ‘value’ of their personal assets like the piano, car and furniture? Well, it could be the same for their ‘business’.

No industry standard

Since there is not an industry standard for this, you’ll have to ask. I would not assume, however, that the amount is based on fair market value or liquidation value. And I would certainly not consider it a liquid asset.

Fruit salad!

For purposes of leverage, we run into a challenge with global cashflow and financial statement analysis of the combined entity/owner. The business financial statements are based on historical costs. You can compare debt-to-equity of one company to another if they are of similar size and type and you are looking at GAAP financial statements for both.

But mix in the personal financial statements, often stated at fair market value, and you quickly get into fruit salad! Apples to oranges instead of apples to apples. I am not saying don’t do it, but be aware that if the resulting leverage ratio looks off it may be because of this mix instead of a company/owner in a better-than or worse-than situation than we would like.

Another problem with leverage ratios for small business

The very reason we look at global analysis is to combine the business with the high % owner. This is because what the owner takes out of the business often has less to do with ‘reasonable’ compensation and more to do with what they want to take home. The capital left in the business is not based on adequate capitalization, since the owner presumably could put the capital back in if needed.

Thus, the leverage ratio on the business alone may not reflect the true picture either. What is a lender to do?

Go ahead and calculate the ratios your guidelines require. Just recognize that anomalies with small- to medium-size businesses, whether based on business-only or global numbers, may be explained by this mish-mash approach to the way we do financial statements. If your numbers are off, consider if there are other ways to determine if the company is still in good shape.

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.

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