Louis Aucamp

INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISE CONFIDENTIAL LESIKA ENTERPRISES MR. SELLO TSUBELE BUSINESS EVALUATION KURAKON Louis Aucamp- tel and fax- LOUIS AUCAMP PAGE I 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES TO WHOM IT MAY CONCERN: RECIPIENTS:  Mr Sello Tsubele  Mr Chris de Klerk  Mr Johan de Klerk This report contains information which is confidential and subject to legal privilege. If you are not the intended recipient, you may not peruse, use, disseminate, distribute or copy this report. If you have received this report in error, please notify the sender immediately by email, facsimile or telephone and return and/or destroy the original report. This report and any supporting information are confidential and intended solely for the use of the individuals or entities to which it is addressed and for the specific purposes that it was intended. LOUIS AUCAMP PAGE II 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES Contents 1 EXECUTIVE SUMMARY.........................................................................................................................- 2 INTRODUCTION ........................................................................................................................................ 4 SCOPE OF ANALYSIS ................................................................................................................................ 4 METHODOLOGY....................................................................................................................................... 4 SUMMARY OF RESULTS AND CONCLUSIONS .......................................................................................... 5 KURAKON CONSTRUCTION (PTY) LTD ........................................................................................... 6 2.1 INTRODUCTION ........................................................................................................................................ 6 2.2 SCOPE OF ANALYSIS ................................................................................................................................ 6 2.3 METHODOLOGY....................................................................................................................................... 7 2.4 RESULTS OF THE ANALYSIS ..................................................................................................................... 7 2.4.1 Financial statements ...................................................................................................................... 7 2.4.2 Financial ratios .............................................................................................................................. 8 2.4.2.1 Short term liabilities ................................................................................................................... 8 2.4.2.2 Solvency ratios ........................................................................................................................... 9 2.4.2.3 Return on investment ratios....................................................................................................... 9 2.4.2.4 Operating performance .............................................................................................................. 9 2.4.2.5 Asset utilisation ........................................................................................................................ 10 2.4.2.6 Failure predictions ................................................................................................................... 10 2.4.2.7 Cash flow management ........................................................................................................... 10 2.4.3 Underground Operations Income and Expenses........................................................................ 10 2.4.4 Business valuation........................................................................................................................ 11 2.4.4.1 Normal discounted cash flow analysis.................................................................................... 11 2.4.4.2 Capital asset and free cash flow models ................................................................................. 12 2.4.4.3 Conclusion ............................................................................................................................... 12 2.4.5 Market value of business based on asset values ......................................................................... 12 3 CONCLUSION............................................................................................................................................ 14 LOUIS AUCAMP PAGE III 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISE Business Investigation for Lesika Enterprises: Kurakon Construction (Pty) Ltd 1 Executive Summary 1.1 Introduction Lesika Enterprises requested a financial analysis on the financial results and assets of Kurakon Construction (Pty) Ltd. with reference to the possible sales transaction being discussed between the parties. 1.2 Scope of Analysis The scope of the analysis was confined to the following:  Scrutiny of financial statements and comments on the findings.  Financial performance evaluation.  Comments on the valuation of the business 1.3 Methodology The analysis consisted of the following actions:  The financial statements were summarised and presented in a standard layout according to the requirements of GAAP and the Companies Act and scrutinised.  Financial ratios and percentages were calculated for each of the years of information supplied.  The income and expenses statements could not be included in the general evaluation as at least 3 years of information is required but has been scrutinised separately.  Business evaluations based on discounted cash flow methodology for various models and scenarios were conducted. LOUIS AUCAMP PAGE 4 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION  LESIKA ENTERPRISES Approximation of market value of the business based on asset and goodwill/intangible asset considerations were conducted. 1.4 Summary of Results and Conclusions  Revenue growth is linked to the cyclical nature of the business but a reasonable expectation would be an increase of 2% especially with the reasonably assured business from underground operations.  Cash flow and working capital management is the crux for survival of the organisation. Due to the cyclical nature of the industry sector, innovative bridging finance arrangements to survive periods of discrepancy between debtor and creditor cycles are very important. Improvements to cash flow may be obtained in the area of director payments and the management of overhead costs.  The operation may be more profitable than reported as the investment into subsidiaries/associated companies increased substantially and needs to be clarified.  The average turnover from underground operations appears to be overstated and need clarification.  Business valuation indicates a present value of the business as a going concern of between R 2.4 million and R 6 million subject to the uncertainty of any future forecasts. The results from 1 model were unreliable and were discarded.  Without conducting a proper asset due diligence no formal asset valuation as understood has been conducted but reference to available information from various sources indicate a total asset value of between R 1.42 million and R 1.75 million as low and high limits for the underground business. Goodwill/intangible assets has been evaluated at between R 200 000 and R 600 000 based on the present value of the underground contracts and the possible extension thereof. LOUIS AUCAMP PAGE 5 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES Kurakon Construction (Pty) Ltd 2 Kurakon Construction (Pty) Ltd 2.1 Introduction The business was established in beginning of the 1980s by the present owners and has been operating in the Secunda area since 1989 as a closed corporation and was converted to a private company in 2001. The company’s main operations are centred around civil engineering construction with 2 separate but integrated areas of operation namely general civil (above ground) specialising in general civil construction with a preference for industrial civil (steel and concrete) and an underground division that construct mining civil structures such as ventilation, walls, seals, bridges, crossings, concrete slabs and sub stations. The company owns the necessary construction equipment and employ ± 120 permanent people at present. 2.2 Scope of analysis Lesika Enterprises have requested an analysis of the performance of Kurakon Construction as part of a decision on the possible purchase of the underground portion of the business with a possibility of considering the above ground portion if feasible. The analysis as contained in this report is limited to financial performance and matters that influence or are important to the financial performance. The scope of the analysis included the following aspects:  Scrutiny of financial statements and comments on the findings.  Financial performance evaluation.  Comments on the valuation of the business The results are subjective and must be used with circumspection. Specific restraints will be pointed out in the relevant sections. LOUIS AUCAMP PAGE 6 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES 2.3 Methodology Four years of financial statements and a list of assets included in the proposed sale transaction with an income and expenses statement for the underground operations from October 2001 to September 2002 and projected income and expenses to May 2003, were supplied by Kurakon Construction. The supplied results were analysed in the following manner:  The financial statements were summarised and presented in a standard layout according to the requirements of GAAP and the Companies Act and scrutinised.  Financial ratios and percentages were calculated for each of the years of information supplied.  The income and expenses statements could not be included in the general evaluation as at least 3 years of information is required but has been scrutinised separately.  Business evaluations based on discounted cash flow methodology for various models and scenarios were conducted.  Approximation of market value of the business based on asset and goodwill/intangible asset considerations were conducted. The inherent deficiencies and constraints applicable to each methodology and method applied will be discussed in the section on results for each. 2.4 Results of the analysis 2.4.1 Financial statements The financial statements have been compiled according to the general requirements of GAAP. The comments apply to the total business as it is not possible to separate the above and below operations on the information received except for the comments on the income and loss statements from October 2001 to May 2003 for the underground operation. After scrutinising the presented financial statements, the following brief general comments are made without any prejudice to any party and without being able to conduct a proper audit and due diligence on the financial processes of the enterprise:  Revenue has grown by 8%, declined by 5% and grown by 24% respectively in 2000, 2001 and 2002. This would in part be ascribed to the cyclical nature of the construction industry and in part to the settlement of underground contracts on a stable allocation basis by Sasol. The underground business is assured of business until 2004 with good prospects of renewal of the contract. The other part of the LOUIS AUCAMP PAGE 7 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES business is more volatile but has more prospects for growth if the Eskom and other contacts are exploited subject to the requirements of qualifying on the black empowerment issues.  Direct construction cost is 64% of revenue and of this labour and subcontractors equates to about 40% to 45% of the costs which is in line with similar operations. Other operating cost is 33% of revenue of which indirect salary cost is 14% of revenue or 50% of Opex. Director’s payment varies according to the financial position of the company but varies from 13% to 25% of operating cost. If the company is taken over by another company that do not have to pay any other directors this is an area where cash flow can be improved. The average net profit margin before interest and tax is 3%. Profit margin after tax is only 0.06% which is considered to be very low but may be due to a deliberate management policy.  Debtors declined from 1999 to 2000, increased by 110% to 2001 and increased by 10% to 2002. Creditors have declined by 3% and then increased by 74% and 36% respectively for the years discussed. This points to a discrepancy in cash flow management but may be due to the cyclical nature of the business.  Investments in subsidiaries/associated companies increased from 15% of assets to 39% of assets from 1999 to 2002. No information on the profitability or risk associated with these investments is available and it is a concern that needs to be taken into consideration.  Book values of the fixed assets are relatively high compared to the market value of the same assets but this may be due to the fact that some assets appear to be relatively new and depreciation periods, that is shorter than the economic life of an asset, has not diluted the book value to the extent that would be expected. 2.4.2 Financial ratios The financial information was utilised to calculate various financial ratios as indicators of the financial performance of the organisation. 2.4.2.1 Short term liabilities The current ratio and acid ratio that measures the ratios between current assets and current liabilities has declined over the period due to a serious decline in working capital (net current assets). This is mainly due to the increase in creditors related to the cyclical nature of the revenue and lack of cash flow. Optimising the cash flow cycle would be accomplished by the negotiation of bridging finance to smooth the cyclical revenue stream but will need to be managed very carefully. LOUIS AUCAMP PAGE 8 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES The debtor payment cycle has been volatile, starting on 40 days declining to 24 days, increasing to 54 days and declining slightly to 48 days. Payments to creditors declined from a 37 day period in 1999 to 67 days in 2002. This is related to the cash flow management problem. The exposure of the directors to an R 950 000 loan presently, which is not reflected in the financial statement period is due to this. From an operational and sustainability viewpoint this seems to be the major area for management focus. 2.4.2.2 Solvency ratios The increase in the gearing ratio that looks at the ratio between total debts and own capital and short term debts indicates the increase in creditors and reinforces the notes on working capital management. Long term debt to equity decreased and then increased to more than 1 which means that the company is very exposed to external debt. The funds flow ratio that measures working capital to total debt has declined due to a decline in working capital because of the increase in creditors over and above debtors and should receive management focus. The coverage of interest payments by net profit has declined to below 1 so that it needs to be carefully managed. The financial leverage ratios support the picture portrayed by the other solvency ratios that the company is a going concern but that careful management of the short term working capital and cash flow must be maintained as the safety margin is very low. The financial leverage index has improved substantially to more than 10 that indicate that asset utilisation is well managed. 2.4.2.3 Return on investment ratios The various return on investment ratios show a mixed picture over the period and support the comments on the importance of careful management of short term current assets. The return on total assets declined from 10% to 3% and the return on equity (own capital invested) improved from 24% to 35% while retained earnings ratio declined from 9% to 7%. The return on equity improvement and the decline in retained earnings ratio could be linked to the investment in subsidiaries/associated companies and needs to be investigated. 2.4.2.4 Operating performance Production efficiency stayed steady at about 36% reflecting a steady ratio between revenue and direct production cost. Operating efficiency declined from 11% to 4% indicating an increase in overheads that need to be investigated and contained and can contribute to an improvement in the working capital/cash flow situation. Inventory turnover increased from 4 times to 6 times and then declined to 2.5 times over the period but is not a concern as inventory is a minor part of working capital. The cash ratio that measures cash to creditors has declined drastically and should receive urgent management attention with the remarks on cash flow management above taken into account. The interval measure that measures the ability to finance operations increased from 45 days to 51 days and should be increased. The interval measure should be higher to allow a safe margin for production given the vulnerability to creditor exposure which is higher than the sustainability measure. LOUIS AUCAMP PAGE 9 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES 2.4.2.5 Asset utilisation The total asset ratio stayed steady over the period and the fixed asset turnover ratio improved during the period showing improved productivity in asset utilisation. The working capital ratio measuring available working capital to total assets has declined from 1% to - 23% mainly due to the increase in creditors over debtors. The comments made above on the working capital and cash flow management is reinforced by this measurement. The decline in working capital turnover to negative proportions reinforces the comments above. 2.4.2.6 Failure predictions Failure predictions models have been developed by various researchers based on data from companies that has gone insolvent. Different models utilise different indicators but most concentrate on asset and liability management indicators. The results from these models should be used with extreme caution and supplemented with other analysis results and the experience of the analyst.. Three models were utilised:  Altman’s model: The company was safe and is now in the indeterminate area  Tafler’s model: No failure predicted  De la Rey’s model: Failure predicted and the results show a worsening of the situation. The Altman and Tafler models show that the company is in a risky situation while the De la Rey model that utilises liquidity ratios are negative and reinforces the comments made on the utmost importance of working capital and cash management. 2.4.2.7 Cash flow management The net calculated cash flow declined and then improved, again emphasising the comments above and should be managed carefully with all the provisos and comments made above in mind. The cash turnover period declined from 4.5 to 3 reinforcing all the comments above. 2.4.3 Underground Operations Income and Expenses The income and expenses information for the period October 2001 to September 2002 has been scrutinised and the following comments are made:  Average income per month seems to be closer to R 300 000 than the R 400 000 stated in the letter of 28/11/2002 from Kurakon to Lesika. LOUIS AUCAMP PAGE 10 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION  LESIKA ENTERPRISES Expenses are only direct expenses and do not include overheads which is an area of concern due to the increase recorded over the previous financial years.  Gross profit margin for the underground operations appears to be better than the average profit margin of 35% for combined operations.  The volatility in the net difference reinforces the comments on working capital and cash flow management made about the combined operations.  The cash flow statement from September 2002 to May 2003 is too generalised to derive any meaningful information from. 2.4.4 Business valuation The value of a business is deemed to be equal to the present value of future income. Forecasts and assumptions on future growth/decline, economic circumstances, and financial circumstances are made and factored into the model and a discounted cash flow technique applied to derive a present value of the business. The techniques must be used with extreme caution as there are many unknowns that influences the results. Sophisticated simulation techniques to analyse the risk and uncertainty exist but was deemed to be outside the scope of this project due to economic, time and effort constraints. The major areas of risk and uncertainty are the following:  Cost of capital to use as discount rate  Economic scenarios and growth rates/decline  Forecasting financial performance  Uncertainty on management and changes in the management environment Various discount models has been utilised and a brief summary of the results are given below. 2.4.4.1 Normal discounted cash flow analysis Based on the supplied financial information various scenarios with different assumptions on sales growth, expenditure growth, inflation, labour cost and economic growth and various time periods were analysed. The scenarios were tested for sensitivity to changes. The results were found to be unreliable as too many variables are sensitive to changes and time periods. LOUIS AUCAMP PAGE 11 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES The results indicated a net business value that fluctuated between R 45 000 to R- depending on scenario and assumptions. 2.4.4.2 Capital asset and free cash flow models Models developed by the Stern Business School of New York University was utilised to analyse the business. 2 models were utilised namely:  A 3 stage model with moderate growth in the initial 2 to 4 years, growth tapering down in the following period and stable low growth/decline there after. Business risk and uncertainty was simulated.  A stable growth decline model for various rates of expansion The results and sensitivity tests indicated that the stable growth model was the closest approximation to the present business circumstances. The results were as follows but should only be viewed as an indication:  With a 5% growth in year 1, 2% in year 2 and declining thereafter to 1.5% the model indicated a business value of R 8.5 million. For various different scenarios including negative growth scenarios the results fluctuated between a low value of R 3 and R 10 million.  The results from the stable growth/decline model indicated business values from R 2.4 to R 4 million. 2.4.4.3 Conclusion The unreliability and uncertainty surrounding the first of the models utilised render the results from it unusable and the results will therefore not be considered in the recommendations. 2.4.5 Market value of business based on asset values An investigation was conducted using the asset list as received. The scope, economic and time constraints precludes this from being a formal asset valuation and it should not be construed as such. Only the assets belonging to the underground operation was evaluated as requested. The methodology followed was as follows:  No information on the condition of the assets except a superficial visual inspection is available.  High and low values for various assets were obtained from publications, internet web sites, trade publications and where unavailable estimates were made. LOUIS AUCAMP PAGE 12 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION  LESIKA ENTERPRISES The asset values were used to derive an indicative low and high value for the business. Due to the specialised nature of the assets and the reluctance of suppliers to supply information without a firm commitment to possible sales it was very difficult to obtain reliable results on replacement values. For some equipment an indication of normal sales prices and an estimation of the cost to flameproof the equipment were utilised. Flame proofing typically increased the estimated value by between R 50 000 and R 200 000. The results indicate a low value of R 1.42 million and a high value of R 1.67 million based on the asset values only. This figure does not include for inventory, goodwill and client base. The intellectual capital/goodwill is very difficult to value and consists of knowledge of the designs and product mix that contributes to the quality and worth of the business, personal relationship and management expertise as well as the reputation of the business and perceptions on quality of the clients. Based solely on the possible present value of the 2 years of underground contracts remaining an intangible value of between R 200 000 and R 600 00 has been estimated. LOUIS AUCAMP PAGE 13 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES 3 Conclusion Based on the available financial information the following comments are presented:  Revenue growth is linked to the cyclical nature of the business but a reasonable expectation would be an increase of 2% especially with the reasonably assured business from underground operations.  Cash flow and working capital management is the crux for survival of the organisation. Due to the cyclical nature of the industry sector, innovative bridging finance arrangements to survive periods of discrepancy between debtor and creditor cycles are very important. Improvements may be obtained in the area of director payments and the management of overhead costs.  The operation may be more profitable than reported as the investment into subsidiaries/associated companies increased substantially and needs to be clarified.  The average turnover from underground operations appears to be overstated and need clarification.  Business valuation indicates a present value of the business as a going concern of between R 2.4 million and R 6 million subject to the uncertainty of any future forecasts. The results from 1 model were unreliable and were discarded.  Without conducting a proper asset due diligence no formal asset valuation as understood has been conducted but reference to available information from various sources indicate a total asset value of between R 1.42 million and R 1.75 million as low and high limits for the underground business. Goodwill/intangible assets has been evaluated at between R 200 000 and R 600 000 based on the present value of the underground contracts and the possible extension thereof. Louis Aucamp ItZ Consulting Services LOUIS AUCAMP PAGE 14 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISE 1999 Financial Ratios 2000 2001 2002 Short term liabilities Current ratio = current assets/current liabilities Acid ratio = (current assets - inventory)/current liabilities Debtor days = (debtors/credit sales) x 360 - - - - - - - - 0.27 1.90 0.28 1.68 0.18 1.80 0.15 3.22 - - - - - - - 0.33 - Solvency Ratios Gearing ratio = (current + longterm liabilities)/(equity capital + current liabilities) Long term debt to equity = long term liabilities/equity capital Times interest earned = net income before interest and tax/interest Financial leverage :- -6.66 #DIV/0! Outside capital leverage = interest/long term liabilities Asset leverage = Assets/equity Return on investment ratios Earning power (return on total assets) = (net income + interest)/total assets Return on equity = (net income + dividends)/equity capital Retained earnings to assets = net retained earnings/total assets Operating performance ratios Production efficiency = gross profit/sales(revenue) Net income to sales = (net profit + dividends)/sales Operating effiency = net operating profit before interest and tax/gross profit Creditors days = (creditors/sales) x 360 Inventory tunover = (Inventory/cost of sales) x 360 Cash ratio = (cash + marketable securities)/current liabilities LOUIS AUCAMP PAGE 15 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES Interval measure = (cash + marketable securities + debtors)/average daily expenses 44.76 26.57 58.81 51.95 - 2.84 5.27 -0.05 -57.46 2.04 4.92 -0.03 -59.82 2.39 5.86 -0.23 -10.47 Asset utilisation ratios Asset turnover = revenue/total assets Fixed asset turnover = revenue/fixed assets Working capital ratio = net working capital/total assets Working capital turnover = revenue/working capital 1999 Failure predictions 2000 2001 2002 Altman: Z = 1.2xA + 1.4xB + 3.3xC + 0.6xD + 0.999xE Z < 1.81 - company will fail 1.81 < Z < 2.99 - area of uncertainty Z > 2.99 - company should be safe 3.19 3.70 2.63 2.48 A = working capital/total assets B = retained earnings/total assets C = net income before interest and tax/total assets D = equity/total debt E = sales/total assets - - - - Taffler: Z = 0.53xA + .013xB + 0.18xC + 0.16xD Z > 0 - no failure predicted 0.08 -0.68 22.86 0.94 A = profit before tax/current liabilities B = current assets/total liabilities C = current liabilities/total assets D = (current assets - stock - current liabilities)/(operating cost + interest depreciation) - - - - -0.21 -4.94 141.97 4.89 De la Rey: K = - 0.01662xA + 0.0111xB + 0.0529xC + 0.076xD -0.79 -0.62 -0.84 -1.19 LOUIS AUCAMP PAGE 16 10/31/2019 INVESTIGATION OF BUSINESS EVALUATION LESIKA ENTERPRISES + 0.0107xE + 0.0107xF -0.06881 K < -0.2 - company will fail -0.2 < K < 0.2 - area of uncertainty K > 0.2 - company should be safe A = (total liabilities/total assets) x 100 B = (net operating profit before interest and tax/total assets) x 100 C = (current assets + investments)/current liabilities D = (earnings after interest/total assets) x 100 E = (cash movement after tax/total assets) x 100 F = (stock/total assets) - - - - - Financial leverage index = return on common equity/return on total assets Index > 1 - positive and beneficial Index = 1 - neutral Index < 1 - negative and detrimental 2.47 2.74 4.23 10.91 Funds flow relationship = working capital/(total debt + preferred stock) 0.01 -0.09 -0.05 -0.29 0 322,121 -221,448 73,112 4.50 5.97 3.01 3.06 - - - - Cash flow management Cashflow = Opening net assets - closing net assets + retained profit + new equity sales proceeds Cash turnover period = 360/(A + B + C) To be kept as high as possible A = (creditors/revenue) x 360 B = (debtors/revenue) x 360 C = (stock/revenue) x 360 LOUIS AUCAMP PAGE 17 10/31/2019