Old Economy >>> New Economy Transformation — Underwriting the numbers

Big Red Car here.  Cold in the ATX.  Brrrr!

But, my friends, the sun is shining and it will be in the high 70s before the day is over.

So I get a question from a reader and they say:  “Big Red Car, this sounds too easy to be true.  How do you underwrite the numbers on an Old Economy company?”

The Old Economy company’s numbers

The Old Economy company is often not going to have very good numbers for you to look at.  This is the nature of Old Economy companies.  Here is what you may find:

1.  Envision a nice little company with a bookkeeper and they may or may not be computerized.  The company often has been in business from well before the advent of personal computers and so what?  Bookkeeper is not enthusiastic about helping you because she knows you will not be keeping her on the job.

2.  The private owner has been running a lot of personal expenses through the company for a number of reasons including to create some questionable tax relief.  Wife’s car?  Ranch expenses?  In the numbers.

3.  Old Economy company owner may be diverting a bit of cash from the business on a daily basis.  Need a new car?  Well, the Old Economy company owner may just take $250 per day in cash until he has enough money to go buy a new SUV.  [pullquote]First challenge is to make order from chaos.  When you make order from chaos, value appears.  Even when it is the numbers.[/pullquote]

4.  No records of any kind at all — just a checkbook and a file folder and a box full of receipts that go to “Morty the Accountant” at year end.

5.  Does not record or realize depreciation.  Leaves that to Morty to sort out.

6.  Bit of “music under the table” — more about that later.

7.  Has not reconciled a bank statement since Eisenhower’s first term as President.

8.  Can’t find historic records of any kind.  Has this year’s numbers only and maybe a few from last year.

First challenge is to make order from chaos.  When you make order from chaos, value appears.  Even when it is the numbers.

So, we are going to have to do some work here to make a bit of order from this chaos.

What do you do to find the truth of things?

You are going to have to construct the numbers yourself.  Not a bad thing in the end.

1.  Hire a computer literate bookkeeper, give him/her a copy of Quicken and enter the checks individually — each and every one of them — and reconstruct the income statement for the Old Economy company from scratch.  Go as far back as you have data.  Sounds like a lot of work, not really.  Piece of cake.

2.  Take the bank statements and check, doublecheck and re-check the bank deposits (and withdrawals or transfers) and any other charges that do not appear in the check book or check register.

3.  Reconcile the bank deposits but don’t obsess on this just yet.

4.  Pro tip: in the age of electronic payments know that there may be some bills paid by ACH or other electronic or digital means.  Look for and verify whether any of these occurred.

5.  Use this info to construct the income statement on a monthly, quarterly and annual basis.  You are doing this in these temporal increments for a reason that will become apparent in just a minute.

6.  With the income statements in hand, reconstruct a statement of cash flows on a monthly, quarterly and annual basis.  This will require information on capital investments, borrowings and capital invested in the business.  You will have to drag some of this out of the Old Economy owner perhaps.

7.  Get a handle on depreciation.  Depreciation is a real cost of doing business.

8.  Do the exact same thing on the balance sheet but wait until you have done the income statements and statement of cash flows before you tackle the balance sheet.  The balance sheet info will require you to go back and tinker with the statement of cash flows.  That is OK, this is an iterative process.

9.  With all of this preliminary information in hand, take a critical look at the Federal income tax statements.  These documents are likely to provide useful “gap” — not GAAP —info because things like depreciation will be smoked out here.

10.  Probe for any “fishy” info like Old Economy owner expenses that are subsumed in the income statement.  Look carefully at any credit cards.  Credit cards are always a problem.

You have now completed the first phase of the financial underwriting.  [Can this be done in some other order or some of the things done simultaneously?  Yes, of course.  But make damn sure you have a plan and don’t disregard any of the individual requirements.]

Preliminary documents

At this instant in time, you now have the following preliminary information in hand:

1.  Monthly, quarterly, annual income statements;

2.  Monthly, quarterly, annual balance sheets;

3.  Monthly, quarterly, annual statements of cash flow;

4.  Monthly, quarterly, annual cash receipts journals;

5.  Monthly, quarterly, annual cash disbursements journals;

6.  An accurate check register;

7.  Reconciled bank statements;

8.  Federal tax returns; and,

9.  A list of “fishy” info.

This information has your fingerprints on it and has been developed in a reliable manner using clean source data.  Take a deep breath and capture your composure.

Look for any discrepancies and smoke out any big problems.  You are now operating a purposeful and intentional higher level of scrutiny.  You are going to finalize each and every set of documents to perfection, if you can.

Proof of cash

With this information in hand, you are now going to conduct a rigorous “proof of cash” tracking the cash that has flowed through the business on a monthly basis.  These cash amounts will have to balance to the bank statements and the Old Economy’s books to the penny or you will have to make discreet adjustments to make it all balance to the penny.

You will surprise yourself that you will either find some gargantuan concerns or it will all just fall into place.

Follow the cash from source to present and make it foot.

This is a different analysis than what has been done already.

Special considerations

There are several areas that demand a very detailed analysis:

1.  Look at all credit cards very carefully to smoke out all costs.

2.  Look at the Old Economy company’s owner’s compensation.  Remember that you will have a cost of management regardless of whether you do it yourself or hire a professional manager and these costs must show up on the income statement.

3.  Take a careful look at the Old Economy’s owner’s expenses particularly things that will not pass muster as it relates to Federal taxes.

4.  If you are buying real estate with the Old Economy company segregate these costs.  These are real costs but the costs must show up in the income statement — perhaps as imputed rent — and the capital expense of the real estate must be in the acquisition numbers.  You cannot buy the business and ignore the cost of the real estate that supports the business.  This is always an issue for the seller because he thinks he should get paid for the real estate in addition to the business.  Work this through in your head carefully.

5.  How many family members are involved in the business and do they really contribute to the business?  Do they replace someone who will have to be hired to replace them?  Or are they ghost employees?  Know the answers and the numbers.

6.  Is there any embezzlement by owner?  Music under the table?

Dig this stuff out.

What do you do with the info?

First, do not show these numbers to the seller — the Old Economy company owner.  Keep them to yourself.

Graph everything — you are looking for the trend and any evidence of seasonality during the year, over the quarters or through the months.  This is one of the reasons why you looked at the info on a monthly, quarterly and annual basis.

Some companies make almost all of their revenue in Q4.  Smoke it out.

If the info supports a lower price then you use it to your advantage — there is a greater probability that you are getting a bit more cash flow than you bargained for because of the potential to remove inappropriate expenses, lower the cost of owner’s compensation and eliminate nepotism.  This is your lagniappe and does not belong to the seller.

Now you are ready to finalize your multiple, put the finishing touch on the final purchase price adjustments, if any, and get the deal closed.

We will talk in more detail about the formal purchase offer in a later post.

You have done a lot of good work thus far, grasshopper.  Well played!

But, hey, what the Hell do I know anyway?  I’m just a Big Red Car.





10 thoughts on “Old Economy >>> New Economy Transformation — Underwriting the numbers

    • .
      Alas, John, there are those who will attempt to evade their “fair share”.

      I find The Boss leaning in that direction more and more given the current situation.

      He will however never pay for someone else’s shortcomings.


    • .
      Thanks, Phil. Anybody who can provide investment advice to the Mob has to be pretty damn good.

      Hope you are well and the sun is shining on you.


  1. Congrats Jeff on your blog. It looks great. I’ll b back to read later today.

    We haven’t had a good argument in awhile. Although they’re always better with drinks.

    • .
      Tom, we are full grown guys. Our ideas may wrestle but we are never disagreeable.

      I respect and appreciate your opinion and ideas. I have learned much from you and I appreciate it.

      When ideas wrestle, better and stronger ideas emerge.

      BRC (JLM)

  2. Great series. The financial due diligence you describe is critical. Many will not have the skills to complete this, but it is imperative to minimizing unpleasant surprises. Frankly, there is much risk in buying old economy companies due to poor record keeping. Of course, there is opportunity here too.

    • .
      Order to chaos requires chaos. Do not fear chaos, worship it.

      Anyone can do this, that is the beauty.

      You may not be able to drive a golf ball like Tiger Woods but you damn sure can think through and putt like him.

      In this approach — Old Economy company to New Economy company — you are starting on the putting green.


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