Normalizing earnings allows one to both compare earning both year over year and against other companies. There are several terms that we use to represent this normalized earnings number. They included SDE (Seller Discretionary Earnings), SDI (Seller Discretionary Income), Adjusted EBITDA, Adjusted Net, or (my favorite) Owner Benefit. While conceptional simple, performing this step is key in valuing a business. It can be difficult to determine and requires more than merely reading the company’s financial statements. Normalizing earnings require detailed analysis as well as an understanding of the company’s current and future operations. As well as discussions with the owner.
Once armed with this knowledge, you can make these adjustments to normalize earnings. Typical typically fall into several categories
- Personal Expenses paid by the business
- Discretionary expenses
- Expenses that don’t use cash
- Nonrecurring and
- Expenses the new owner will not incur.
Before we get into the above, consideration must be given to whether the financial are on a cash or accrual basis of accounting. Without getting into all the difference most small business keep their books on an accrual basis – actually a modified accrual basis. To keep it simple in an accrual basis of account Sales are recognized when made not when cash is received. So, sales usually appear higher than on a cash basis where sales are recognized when cash is received. A side effect is that in theory there are no accounts receivable in a cash-based accounting system. Therefore, you can’t extend credit, not even for a day. In an accrual-based accounting system, you account for expenses even though you may not have been billed for them. Example (not a likely one), lets say you are billed for rent quarterly but under an accrual-based system you would book rent every month. So generally speaking, smaller business keep their books on an accrual bases and do taxes on a Cash Bases (usually lowers profit – reduces taxes). The reason I said modified accrual is that most smaller business don’t book expenses properly. That is, they book them when received and not when incurred. Thus, choosing which method of accounting can affect your profitability.
Now, let’s speak about the adjustments to profit or what we typically call “add backs”.
In smaller sized business certain type of expenses back. The simplest one is the owner’s salary. As the owner keeps the “profit” of the business, simplistically what the owner makes is their salary plus the profit. In line with this, we also add back the payroll of non-working family members. However, sometimes we have to adjust for family members that are underpaid (this reduce profit) and sometimes we adjust for overpaid family members (this increase profit) and yes, in all cases we adjust for payroll taxes. To this, we also adjust for personal expenses paid by the business. Example of this are personal vehicles, personal travel & entertainment, and non-business-related meals among other personal expenses.
Next, we add back what are call discretionary expenses. Examples include: Charitable donations – which while certainly a good thing to do, they are not required to run the business. Dues are another example of add backs. This one however is tricky. Example while some might question the need to belong to a country club, however, it may be the source of significant business. Belong to a professional organization may enhance the image of the business or be a requirement of the type of business e.g. the Bar Association of a particular state. So, when dues to an organization are not beneficial to the business, we increase profit by that amount.
The next category I call “Expenses that don’t use cash”. The best example of this is depreciation. If you think about it, depreciation uses no cash. The cash was used at the time of purchase but not annually. Depreciation is just expense the purchase over a give period of time (its life – not going to discuss the various tax issues) rather the when purchased. Thus, you add back depreciation and similar items. This category is very limited.
The next add back category is non-recurring expenses. Example payments related to settling a lawsuit including legal fees. Another is you hired a consultant to improve operations. In other words, expenses that won’t occur every year. However, you need to be careful. For example, if you hire a consultant to maintain your website but while they might not work for you every month each year you will hire them to do something.
The last add back category is expense the new owner will not have. The best example of this is interest expense. As in most situation you by assets and it is assumed that you will have not have a loan, all loan/lease expenses tend to go away. Now I recognize that many will take out a loan to by the business or have a lease for equipment. That is a choice and not a requirement. The money used, now becomes available to the new business to pay for such expenses and therefore is an add back to the profit.
If you would like to see how this works, try either our simple or advanced valuation calculator – https://anchorbusinessbrokers.com/value-my-business/. The advance calculator lays out the process in more detail and will give you both better results and a better understanding of the process.