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Evaluation – Buying A Company For It’s Property Assets
Financial statements can be generally be said as a summary of financial performance throughout a specified period of time. They need to adhere to accounting standards when they are filed for tax purposes. However, it is common for organisations to have 2 set of accounts. One that adhere to accounting standards that meet regulatory requirements. And another for internal use as management may have their own preferences on how to view their financial performance. This other set accounts is commonly known as “management accounts”. The financial statements that you are assessing can have different standards to follow depending on which part of the world you are at.
Trying to make sense of a company’s financial statements can be a daunting task. You might have failed at maths and your accountant has started to chicken out from your constant harassment for free advice. But if you are buying property assets via buying over a company, these are documents that you have to adsorb and decipher whether it is a good buy or not. Not only does financial statements show the financial health of the company holding those assets, it also gives an insight of potential future performance. If you are still wondering why for goodness sake can’t someone just buy the property instead of the company, the answer lies in stamp duties and taxes.
For a start, you will want to get access to at least 3 years worth of the most recent financial statements. Key statements include the profit & loss statement, balance sheet, and cash flow statement. The P&L shows how much revenue is generated and how much expenses were incurred to generate those income. The balance sheet shows the book value of assets and liability obligations. And the cash flow statement give you an in-depth look on the money movements in and out of the company. If you are getting serious in buying a multi-property portfolio or a multifamily complex, you MUST get your realtor or seller to furnish you with these statements. Here are 9 key items that you absolutely have to review.
1) Profit. It goes without saying that you want to buy a company that is profitable unless you know something about the properties in question in a way like no one else does. For example, you might have inside information about a potential en-bloc sale. Some people put more emphasis on gross profits while most are only focused on net profit. The trick is that if you can pinpoint the expense items that are eating into gross profits, you can then play around managing those expenses to achieve a better net profit. Sometimes a company is actually loss making but shows a net profit on it’s profit & loss. This can be due to one-off extraordinary items are even bad debts written off. Or even exceptionally high depreciation. To be prudent, you should exclude these items that does not show a real representation of company operations.
2) Revenue. For a lot of people, the strength of a company is determined in the revenue it generates. In your case, the revenue generated by the company you are evaluating comes from rentals. When there is good revenue growth even though property assets have not changed in recent years, it is an indication that rentals have been revising upwards. And if the company is managing the property assets itself, you might find that revenue is also generated from managements fee, maintenance services, basic contracting etc. So if you plan to be a passive investor and outsource the management of properties, remember to factor this in. Because in this case only the revenue generated from rental will be relevant. However if the costs of managing the property is lower than a professional management company, it could be wise to continue to self-manage. Finally, make a mental note of how the company recognizes revenue. Does it take the total rentals from the whole tenancy agreement? Or records revenue from rental collections month by month?
3) Bonuses. When you are dealing with a private company, there is tendency for Directors or major shareholders to pay themselves with bonuses and Director fees. There are accounting reasons for these. But going into those are not the purpose of this article. If you do takeover the company, these bonuses of course will become yours. However, you might want to use those monies for more investments instead. Another thing to take note of are the bonuses of the staff. If they are consistently getting attractive bonuses, you might have to keep up with the trend to retain them. Good efficient staff who knows exactly how to do the job on hand are difficult to find. It may cost you more money to hire new staff and train them to your requirements.
4) Debt. Every company will have some debt. The key aspect is to determine whether debt is rising, reducing, or constantly stable. Depending on your investment appetite, some investors view higher debts as a good sign of using leverage, while other investors might feel that it is bad money management. To get a feel of how healthy is the debt, take the average debt per month divided by average monthly income. A figure below 50% is healthy. Even a figure up to 75% is not as bad as it might seem to you. Businesses run their operations through debt. You will not find a company with zero debt. If you see one, it is a sign that the company has a lot of room to grow.
5) Cash flow. Warren Buffet is famous for saying that cash flow is what he really looks for when analyzing a company’s financial performance. A lot of companies fail even though they are profitable due to cash flow problems. In times of economic shocks, cash is king as credit is unavailable. Cash flow is critical for your monthly commitments like mortgage repayments and maintenance. Watch for for consistent cash inflows as how a property rental business should be. Any inconsistencies in cash inflows should immediately trigger you to ask more questions.
6) Property valuation. The figure you see in the balance sheet that reflect the property value takes into account depreciation. To get an indication for the property market value, it is best that you hire a property valuer to value the properties. Then compare the value to properties in the vicinity. If you choose to value the company instead of the property assets. Take note that accountants usually value a company by taking into account projected profits for the next 10 years. You will need to use valuation ratios if you take this route of valuation.
7) Recurring costs. One-off expenses are easily to slice if you can find a cheaper alternative. But if you have a fixed recurring costs, it becomes something that you cannot eliminate in the short term. Examples of such costs are debt liabilities and your own rentals. Having a fixed rental recurring cost might sound weird to you as you are the landlord. Those in the subletting business will be familiar with this as they rent from a landlord and sublet to tenants. If there are constant costs that relates to improving the property assets, make sure the valuation reflects these improvements.
8) Prospects. Financial statements contain how Directors view the prospects of the company over the short and long term. If the statements are audited by professional accountants, the accountants will include their opinions on the business viability as well. Look out for accounts with qualifications and dig deeper when they arise. Directors’ outlook are usually more bullish while accountants are more pragmatic. But also take into account that Directors understand the business and market in a way that accountants do not. If you are buying over the company, you should come to your own conclusions on the outlook of your investment.
9) Managements changes. Often times, when a company buys over another, a key condition for the transaction to follow through is that key management staff are retained for a specific period of time. If the current crop of talent is able to run the company properly, why change them? Depending on your plans for the takeover, you have to decide what is best for your investment. You should also have a lookout in the financial statements of whether there were management changes in the recent past. Management changes could have huge implications on what was happening in the company in the past and as of now.