One of the most difficult aspects of acquiring a business is understanding how much money a business owner is truly making. If the 5.6 million-word tax code doesn’t make it difficult enough, business owners and their accountants sometimes add to the confusion with their creative bookkeeping techniques.
You’ve probably heard a dozen terms that describe the profit of a business – Cash Flow, True Owner Net, Seller’s Discretionary Earnings (SDE), Seller’s Discretionary Cash Flow, Owner Benefit, Adjusted EBITDA. These terms essentially all answer the same question – how much money does the owner really make?
What you have to understand and accept first, before even looking at a financial statement or report, is that the objective of a business owner is to make as much money and pay as little tax as possible, and that accountants and CPAs find ways to help business owners accomplish this goal. This can make your attempt to determine true cash flow a little more difficult, but always keep one thing in mind – business owners have to prove what they claim.
The first step taken in determining a business’ cash flow is to recast the financials. Recasting financials is a fancy term that simply means correcting, normalizing or adjusting them, to provide a more accurate picture of what the business is truly producing in regards to profit. When financials are recasted, the goal is to find expenses to add back into the net profit of the business – we call these items add-backs or adjustments.
Start with EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This simply refers to a business’ profit before any interest, certain taxes, depreciation and amortization are deducted as expenses. Depreciation and amortization are non-cash expenses, meaning they are booked as expenses and come off the bottom line, but there isn’t actually any expense being paid out by the company in real cash. As for interest and certain taxes, they are added back because the new owner will not be incurring these same expenses.
Owner’s Salary and Benefits
Don’t forget about the owner’s salary, or any payouts to partners or other family members that are shown as expenses. These items are added back too. This also goes for other legitimate business expenses that benefit the owner, such as health insurance, life insurance, 401(k) matching or other employment costs. Keep in mind, while these salaries and benefits are legitimate adjustments, there may also need to be a counter-adjustment to cover any replacement salaries for positions needing to be filled after certain roles are vacated by exiting family.
Fringe Benefits and Other Personal Expenses
As a rule-of-thumb, anything that is a personal expense is an add-back. It’s typical for owners to run some expenses through the business that are actually more personal in nature than business. This commonly can include items such as meals, entertainment, travel, family cell phone plans and personal vehicles, for example. Keep in mind that some of these items could be a combination of both personal and business expenses, so only and add back the portion of the expense that is truly for personal use.
In addition to personal expenses, there’s also discretionary spending to account for. These expenses can include charitable donations, excessive legal fees or season tickets to a local sporting venue – specific items that are categorized as legitimate business expenses, but are not mandatory to operate the company successfully. Hence, discretionary, meaning a new owner can choose not to spend this money and the business will not suffer.
Another major add-back can be the one-time, non-recurring or extraordinary expenses. Maybe a business owner paid cash for a new piece of equipment instead of capitalizing it, maybe there was a major repair that had to be done to the building after a storm, or maybe the business relocated and incurred moving expenses. These are examples of legitimate business expenses that were unique and only appear once in several years of financial records. Those items are added back in because they skew the normal cash flow picture of the business.
Once the financial statements have been examined and all of these different types of adjustments have been identified and added back, the recasting is complete. Now there is a very clear understanding of what the business’ true cash flow is. Think of it as a pot of money at the end of the recasting rainbow – then it’s up the new owner of the business to determine how they want to run the books, and allocate those funds as they see fit.