Accounting and Business valuation methods

Accounting and Business

Valuation Methods

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Accounting and Business

Valuation Methods

Malcolm K. Howard

AMSTERDAM • BOSTON • HEIDELBERG • LONDON

NEW YORK • OXFORD • PARIS • SAN DIEGO

SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO

CIMA Publishing is an imprint of Elsevier

CIMA Publishing is an imprint of Elsevier

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First edition 2008

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Contents

List of Figures ix

Acknowledgements xi

Introduction: How to interpret IFRS Accounts xiii

1 Telling the story 1

Basic principles of accounting 3

Case study – Amanda 7

Value added tax 10

Amanda’s transactions 13

Amanda’s reconciliations 21

The Trial Balance 24

The Profit and Loss Account 29

The Balance Sheet 34

Case study – Amanda 43

The working capital cycle 43

Negotiating with banks 45

Asset management 50

Amanda’s meetings 60

Discussion Questions 62

2 Capital structure and basic tools of analysis 65

Case study – Amanda’s lawyer introduces her to a

financial adviser 67

Capital structures – venture capital (private equity)

Case Study – Amanda’s meeting her solicitor and his

68

The Enterprise Investment Scheme 71

Investment rules 75

Venture capital trusts 76

The Alternative Investment Market 77

Capital structures 78

Gearing 87

The weighted cost of capital 88

recommended financial adviser 89

The financial planning process 90

v

Contents

Case study – Amanda – the deal structure 103

Capital structure summary and exit strategies 118

Basic tools of analysis 119

The key ratios 128

Case study – Amanda’ completion meeting 132

Discussion Questions 133

3 Financial reporting and IFRS 137

Accounting is a series of judgements 139

The Auditors’ Report and their responsibilities 143

The limitations of the Independent Auditors’ Report 144

What happens when directors and auditors cannot agree 146

International Financial Reporting Standards 147

Revenue recognition 156

Research and development (notes 1 and 9) 157

Share-based payments (notes 2 and 8) 157

Intangible assets (notes 1 and 3) 165

Investment property and investment property under

development (Case Study: UNITE Group plc) 167

Dividends (note 4) 171

Salary-related pension schemes (note 5) 172

Financial derivatives (note 11) 175

Leases 178

Minor adjustments 179

IFRS vs. UK GAAP summary 179

Corporate governance 181

The Report of the Directors 184

The Directors’ Remuneration Report 185

Optional (non-statutory) reports 185

Annual Report – Summary 186

The Sarbanes-Oxley Act 187

Shareholders’ power 190

Discussion Questions 191

4 Assessing risk and valuing companies 193

Amanda – Case Study – The acquisition of her company 195

Choice of investments 196

Risk 196

Portfolio theory 198

vi

Contents

The experiment 203

Risks associated with taking on unique risk 207

Assessing company performance 209

Basic checks 218

Valuation techniques 222

The BVCA Code of Conduct 222

Final Review 234

Why the market sometimes gets it painfully wrong 239

Restructuring – a strategy to move the share price upwards 240

Profit Warnings 241

Takeover bids 243

Case study – Amanda – the conclusion 244

Discussion Questions 245

Case studies 247

Solutions to discussion questions 275

References 283

Index 289

vii

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List of Figures

Figure 1.1 Case study – Amanda – transactions (double entry) 14

Figure 1.2 Case study – Amanda – Trial Balance 25

Figure 1.3 Case study – Amanda – Profit and Loss Account 34

Figure 1.4(a) Case study – Amanda – Balance Sheet (prior to UK

GAAP) 35

Figure 1.4(b) Case study – Amanda – Balance Sheet 36

Figure 1.5 Case study – Amanda – Trial Balance (after completion

of 2004 accounts) 41

Figure 1.6 Case study – Amanda – reversible entries 42

Figure 2.1 Case study – Amanda – 5-year plan – base estimates 91

Figure 2.2 Case study – Amanda – 5-year plan – Earnings Statement

(prior to equity investment) 95

Figure 2.3 Case study – Amanda – 5-year plan – Balance Sheet

(prior to equity investment) 97

Figure 2.4 Case study – Amanda – 5-year plan – calculation of loans

and interest (prior to equity investment) 102

Figure 2.5 Case study – Amanda – 5-year plan – Earnings Statement 108

Figure 2.6 Case study – Amanda – 5-year plan – Balance Sheet 109

Figure 2.7 Case study – Amanda – 5-year plan – calculation of loans

and interest 111

Figure 2.8 Case study – Amanda – 5-year plan – Cash Flow

Statement 114

Figure 2.9 A Food Manufacturing Co. – Profit and Loss Account and

Balance Sheet 120

Figure 2.10 A Food Manufacturing Co. – Cash Flow Statement 131

Figure 3.1 A Food Manufacturing Co. – Profit and Loss Account

(IFRS vs. UK GAAP) 151

Figure 3.2 A Food Manufacturing Co. – Balance Sheet (IFRS vs.

UK GAAP) 152

Figure 3.3 A Food Manufacturing Co. – Cash Flow Statement (IFRS

vs. UK GAAP) 153

Figure 3.4 UNITE Group plc – Income Statement for 2004 to 2006 168

Figure 3.5 UNITE Group plc – Balance Sheet for 2004 to 2006 169

Figure 4.1 Con Glomerate plc – Income Statement for year ended

31 December 2006 210

Figure 4.2 Con Glomerate plc – Balance Sheet at 31 December 2006 211

ix

List of Figures

Figure 4.3 Con Glomerate plc – Part Cash Flow Statement for the

year 31 December 2006 212

Figure 4.4 Con Glomerate plc – revised Earnings Statement (revised

Figure 4.1) 214

Figure 4.5 Con Glomerate plc – revised Part Cash Flow Statement

(revised Figure 4.3) 217

Figure 4.6 Formula to calculate discount factors 219

Figure 4.7 Discounted cash flow for Con Glomerate plc 220

Figure 4.8 Con Glomerate plc – growth factor required to achieve

a 15% return 221

Figure 4.9 Formula to calculate growth built into share price 228

Figure 4.10 Formula to calculate price needed to achieve IRR with

forecast growth 229

Figure 4.11 Formula to calculate growth built into share price –

Con Glomerate plc 230

Figure 4.12 Formula to calculate Con Glomerate’s share price to

achieve IRR 231

x

Acknowledgements

The author would like to thank the following individuals:

Michael Glover for suggesting this book should be written in the first place and

for his editing of the HgCapital Trust plc case study.

Dr Dermot Golden, Paddy Power plc’s Head of Risk, for the help in writing that

company’s case study.

His son, Philip Howard, a mathematics graduate from Pembroke College,

Oxford, for providing and explaining the Black-Scholes formula.

Geoffrey Pickerill, a lawyer specialising in mergers and acquisitions, for his

valuable advice.

The author would also like to thank the following organisations:

The British Venture Capital Association for granting permission to reproduce

their Code of Conduct and extracts from their ‘International Private Equity And

Venture Capital Valuation Guidelines’.

Oxford University Press for granting permission to reproduce extracts from

‘3i – Fifty Years Investing in Industry’.

In addition, the author would like to thank the directors of the following

companies for granting permission to reproduce their company’s accounts:

HgCapital Trust plc

Morrison (Wm) Supermarkets plc

Paddy Power plc

Topps Tiles plc

UNITE Group plc

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Introduction: How to interpret IFRS Accounts

This book explains the methods used in accounting and business valuations

by using the fictional story of a new start-up business, from original concept to

eventual acquisition. Enamoured with entrepreneurial spirit, a business woman

buys her family’s secret salad dressing recipe from her brother and sets up a

business. Chapter 1 illustrates double entry bookkeeping and how to prepare

a Trial Balance, Profit and Loss Account and Balance Sheet and also discusses

the working capital cycle, asset management and how to negotiate with banks.

At the forefront of this chapter is how the combination of inexperience and

insufficient funds can lead to near disaster, which is clearly illustrated via the

fictional story.

Chapter 2 shows how to produce a 5-year plan and discusses capital structures

and the importance of getting gearing right. The fictional business woman,

Amanda, raises equity through a wealthy business angel who operates as if he

were a venture capital firm. This chapter discusses the basic tools of analysis

to enable Amanda to assess her business and which ratios are of utmost impor￾tance in certain circumstances. Finally, Amanda is made aware that controlling

cash is a key requirement in any business and why the Cash Flow Statement is

probably the most important statement in a set of accounts. The reader learns

the possible exit strategies for a small business in this position.

Chapter 3 covers financial reporting and the International Financial Reporting

Standards (IFRS) used by quoted companies that replaced UK GAAP (generally

accepted accounting principles). We see that the Profit and Loss Account is

replaced by an Income Statement and that the Balance Sheet and Cash Flow

Statement use different terminology and have a different format than before.

We discuss the essential changes from UK GAAP to IFRS being the move

away from historical cost accounting to fair value accounting and how the new

system is less prudent than the old.

In Chapter 4, Amanda receives a telephone call that leads to the sale of her

business and a new company is set up by her acquirer. She becomes a director

of the new company: after all taxes are paid she has over £1 million in the bank

and considers building an external portfolio. This chapter illustrates how IFRS

accounts might be interpreted and how such evaluations can sometimes give

the assessor a small advantage in the market place. Different methods used

xiii

Introduction: How to interpret IFRS Accounts

to value companies are illustrated. Four case studies featuring real events and

real company accounts illustrate the points made in this chapter.

Accounting students are often faced with a series of bland exercises, none of

which relates to each other; accordingly, to many the subject is uninteresting.

But accounts often tell an interesting story, in numbers rather than in words.

The fictional story of Amanda was chosen to illustrate this, but in addition it is

designed to help readers with entrepreneurial spirit to understand the financial

challenges they will face when they start a business and how they might make

profitable investments after they have been successful.

xiv