Capital For Value Profile picture
May 31 7 tweets 2 min read Twitter logo Read on Twitter
#SMB Value tip:

How to remove excess or non-operating compensation or increase compensation in the financial statements during the normalization process

Its better to normalize earnings of a potential acquisition b/c you, as the new owner, can change this

👇
1/x Many times owners pay themselves over or under a replacement compensation (mainly due to tax reasons)

Many Owners may be paying family members higher than normal compensation rates

These items should be adjusted to 'normalize' the financial statements
2/x When buying a company you are gaining control

As a control adjustment you can operate the biz as you please & so its common to make control type adjustments such as normalizing compensation

A compensation adjustment is a controlling adjustment for valuation purposes
3/x
When adjusting compensation you must do 2 things, 1 normalize comp
2 normalize payroll tax

Payroll tax affects owners of S Corps & C Corps. LLC's have owner draws & no payroll tax

In general, the biz pays half the payroll tax & the employee pays the other half (7.65%)
4/x
When to normalize Payroll tax:
- Owner is leaving (& is taxed by the legal entity) & an employee is replacing them
- When an owner comp is adjusted for an an S or C Corp
- If an employee needs to be added, removed, or normalized
5/x To adjust compensation take your EBITDA:
1 Add back current salary
2 Add back payroll tax (~7.65%)
3 Deduct Market Comp
4 Deduct payroll tax (~7.65%)

(if removing an employee, do steps 1 & 2 only) Image
6/x
Be sure to normalize compensation & payroll tax when adjusting compensation

It's a straightforward procedure but crucial to get right

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More from @Capital4Value

May 31
#SMB Value Tip:
Not all Revenue is created Equal

Cash or Accrual bookkeeping track revenues differently

-Cash is the ACTUAL cash revenue in the bank for the period
-Accrual shows the BILLED revenue (uncollected)

Accounts Receivables helps bridge the gap

Let's explore...👇
1/x
Depending on the biz size, accounting may elect for Cash or Accrual books

Many #SMB use Cash books due to its ease of use & practical nature

Larger firms may use Accrual books due to its advanced ability to track assets & liabilities, & match revenues with expenses
2/x
Revenue under Cash is the cash deposited into the account

Revenue under Accrual books is the cash billed to customers but not collected

Accounts Receivable (A/R) should be tracked for both books

But Cash books will NOT show A/R on the Balance Sheet & is tracked separate
Read 7 tweets
Mar 7
#smb #investing
Want a quick "back of the napkin" forecasting tool to estimate future capital requirements?

Use the Sales-to-Capital ratio

Total Capital = NWC + PPE, net + Goodwill/Intangibles
(For private co with accel depr use gross PPE)

Explanation... 👇
1/x
What is it?
Sales to capital (S/C) ratio looks at how much revenue a company generate per $1 of capital

$1mm of revenue using $600K of capital equates to a 1.66x Sales to Capital ratio

Why does this matter? 👇
2/x
Observations:
- The ratio is industry specific - unit economics influence & bound the ratio
- For established co's, the S/C ratio is fairly stable & can increase over time
- For young co's, it is generally low, but will increase over time
Read 6 tweets
Sep 16, 2022
1/X @realEstateTrent A response to to your tweet re: rising rates & RE cap rates

Any investment, business or real estate, requires the investor to discount the future cash flows based on the required return

Here is how investors determine the required return (aka discount rate)
2/X A discount rate matches cash flows (CF)

• A CF to equity holders only = use equity discount rate
• A CF to Invested Capital (or NOI in Real Estate) uses a weighted average cost of capital (WACC) of debt & Equity

Let’s see how the equity & debt rates are calculated…
3/X Equity discount rate

Can use the build up method (BUM) - I think it’s intuitive:

Risk free rate
+Return Risk Premium (return over Govt bonds) many use historical returns
+ Idiosyncratic risk Premium
= Total Equity Discount Rate

A real world example using Real Estate…
Read 16 tweets
Sep 15, 2022
A Sources and Uses analysis for any company can be helpful when analyzing a potential investment
#SMB #investing #valuation

Let's look at $ADBE 👇(1-5) Image
1/5 $ADBE 's
Sources: Primarily cash flow from operations. Debt is used for acquisitions.

Uses: A capital light business so little on Capex. The main uses are M&A and Buybacks.

Let's review why $ADBE buys back so much stock, but first we need to look at returns on capital Image
2/5 During past 5 years, $ADBE increased sales by $8.5b, and Opr Inc by $3.6b for an incremental margin of 42.8%

Same period, added $8.6b in total capital & generated a 42% return on that capital. Impressive!

Total capital incudes NWC, PPE, & Goodwill/Intangibles Image
Read 6 tweets
Sep 14, 2022
#SMB Finance Tip

Want to tie up less Capital in your business?

If your cash conversion cycle (CCC) is POSITIVE, then that means you need Working Capital funded by the Owner to operate the business.

Let’s explore 👇🏼
1/9 The CCC is a comprised of 3 things:
1. How quickly sales turn to cash aka Days Sales Outstanding (DSO)
2. How quickly inventory turns to cash (Aka DIO) (exclude if a service biz)
3. How quickly you must pay suppliers/ vendors, payables (aka DPO)

The formula 👇🏼
2/9
DSO + DIO - DIO = CCC

In layman terms
The company’s ability to convert operations to cash is a function of collecting cash sales (DSO) PLUS how quickly it can sell inventory (DIO) MINUS how quickly it needs to pay everyone

The result is the number of DAYS this process takes
Read 10 tweets
Apr 8, 2022
Value tip: Look at both ROIC for TANGIBLE and TOTAL capital

The difference is acquisitions/goodwill. The fundamental economics of a business don’t change if a high/low premium is paid

$AMZN
5 yr avg ROIC
Tangible: 15.7%
Total: 10.8%
Cost of Cap= 7%
👇🏼

#valuation #investing
1/ Company’s will pay high premiums for a good biz. Classic example is Kraft-Heinz. Both CO’s had high ROIC Tangible Capital combined at 30%.

BUT the TOTAL ROIC after the merger was 6%.

Went from 30% to 6%. Why?

They paid too high a price.
2/ Tangible ROIC like Kraft-Heinz make investors salivate. You cannot buy a biz for the invested capital (IC) amount only. No one would sell it since the IC generates valuable cash flows.

BUT paying too much for the cash flows reduces any benefits of the high Tangible ROIC biz
Read 7 tweets

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