One of the most difficult aspects of valuing a business is understanding how much money the business owner is truly making. There are a dozen terms to describe the profit of a business – Cash Flow, True Owner Net, Seller’s Discretionary Earnings (SDE), Seller’s Discretionary Cash Flow, Owner Benefit, EBITDA – these terms all pretty much answer the same question … how much money does the owner really make?
What we understand and accept, even before we look at your financial statement or report, is that your objective is to make as much money and pay as little tax as possible, and that “good” accountants and CPAs find ways to help business owners accomplish this goal. This can make our attempt to determine true profit or cash flow of the business a little more difficult, but always keep one thing in mind – the money is there … we just have to find it. In fact, over the years of selling businesses most business owners are shocked at the “benefits” that they have received each year.
The first step we take in determining a business’ cash flow is to recast the financials. Recasting financials is a fancy term that simply means we “correct” them, or adjust them, to provide a more accurate picture of what the business is truly producing in regards to profit. When we recast financials, we are looking for expenses to “add back” into the net profit of the business – we call these items add-backs, or fringe benefits. This isn’t to say that you should have reported them differently to the IRS but rather these are expenses that a prospective buyer wouldn’t consider as necessary for the operation of the business.
As a rule-of-thumb, anything that is a personal expense is an add-back. This commonly includes items such as family cell phone plans, family health insurance coverage, personal vehicles and meals. Keep in mind that some of these items could be a combination of both personal and business expenses, so we must be careful only to add back the portion of the expense that is truly for personal use. Please note that we also can only “add-back” expenses that were expensed on the Profit and Loss statement and/or tax return.
In addition to personal expenses, we also have discretionary spending to account for. These expenses can include charitable donations, excessive legal fees or season tickets to a local sporting venue. What we are looking for here are specific items, although they are often legitimate business expenses, that are not mandatory to operate the business – 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 expense. Maybe a business owner paid cash for a new piece of equipment, maybe there was a major repair that had to be done to the building after a storm, or maybe the business owner hired a consultant to evaluate his operational processes. These are all examples of legitimate business expenses that were unique and only appear once in several years of financial records. We add those items back in because they skew the “normal” cash flow picture of the business.
Don’t forget about your (owner’s) salary, or any payouts to partners or other family members that are shown as expenses on the Profit and Loss statement and/or Tax Return. We add these items back too. They are the easiest expenses to add back because the perspective buyer is able to consider this profit or pay that they are able to take as the next owner of the business.
A note on EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This simply refers to a business’ profit before any interest, certain taxes (such as income), depreciation and amortization are deducted. EBITDA is the most widely-accepted indicator of a business’ profitability, and any CPA will tell you it is universally accepted. EBITDA becomes less relevant as businesses become smaller in size, but nonetheless those items are still added back in our recast. To be clear we add back interest, income tax, Depreciation and Amortization.
We find many business owners that will take the time to go line by line through their Profit and Loss and clicking on each line and drilling down to the actual expense. This is a tedious task that can result in exponentially great value of your company.
So once we have examined the financial statements and determined what personal expenses, discretionary spending, non-recurring charges, owner’s salary and EBITDA items should be added back, we have completed the recasting of the financials. Now we have 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 to the new owner of the business to determine how they want to run the books of their company.