The prospective buyer of an auto repair shop for sale in Central California noticed, while conducting due-diligence, that an office assistant was listed on the payroll. But he'd visited the business as a customer and had never seen anyone working in the office.
When inquiring about this, he learned that a "salary" of $1,500 per month was being paid to the seller's sister-in-law, and that she was listed as an office assistant, but didn't actually work at the company.
That's an "add-back" and it should be included with net incomeŁ the seller said.
The buyer was troubled by this discovery. Also confusing was the seller's assertion that auto expenses, such as gas and insurance charged off as business costs, should be added back to profits.
These are just two examples of the many questions and sources of confusions that can surface when trying to understand the actual costs involved with operation of a business. The confusion comes about because many, if not most sellers attempt to show as little income as possible to reduce the taxes that have to be paid. Then, when it's time to sell, the business owner has the opposite objective, wanting to show as much earnings as possible to justify the price being asked for the business.
The typical way of resolving this dilemma is for the seller to point out the costs charged off to the business but not really necessary to operate.
These explanations, however, sometimes raise more questions than they answer.
When the buyer who was investigating the auto repair business for sale looked into what the seller was saying, he learned that although there was no one physically present in the office during business hours, it was necessary to have someone handling office work. The sister in law came in on evenings or weekends to balance the company check book, verify that all parts ordered were charged against repair orders, to compare vendor statements with individual invoices, handle payroll and sales tax responsibilities and take care of related duties.
And while it was true that the seller was charging the business for his personal auto expenses, it also was the fact that the car was used for needed business activities such as picking up parts and taking customers to their home or office.
A well prepared adjusted profit and loss statement anticipates buyer questions and clearly defines what expenses on the operating statement are, and what are not necessary for efficient management of the business. But not every seller or business broker knows how to provide that information in a way that's easy to understand. And not everyone is willing to engage in full and complete disclosure.
It's up to the careful buyer to question every item on the income and expense statement. And to ask questions such as:
- Is each itemized expense necessary in order to operate the business properly?
- Is the listed total for each item the actual expense, or is the real cost lower, or higher than what has been entered in the books?
- What was the ratio of the amount in each expense item to the total of all expenses for the last complete year? How does that figure compare to the percentages in prior years? If there is a substantial change in any single category, what is the reason?
The smart business buyer does not accept, without question, the figures listed in the P&L and financials of a company being considered, but does some investigating to learn what the figures actually represent.
To see what other professionals have to say about Adjusted Net Income, SDE (Sellers Discretionary Cash) and Cash Flow go to the BizBen Glossary definition of Adjusted Net Income and read some great contributions and examples!
About This Contributor: Peter Siegel, MBA is the Senior Advisor (BizBen ProBuy & ProSell Programs & Business Purchase Financing Expert). BizBen was established 1994, with 8000+ CA businesses for sale, 500 new & refreshed postings/posts daily. Peter works with business buyers, owners/sellers, brokers, agents, intermediaries, investors, & advisors. Reach him direct at 866-270-6278 to discuss strategies regarding buying, selling, (or financing a puchase of) California businesses.
Categories: BizBen Blog Contributor, Business Purchase Financing, Business Valuation Issues, Deal And Escrow Issues, How To Buy A Business, How To Sell A Business, Small Business Financing
Comments Regarding This Blog Post
Buyers and sellers should be aware of the many items that are generally included as SDE-calculation "add-backs". Those typically recognized without question by SBA lenders are: depreciation and amortization, business interest, salary for one owner-manager, and payroll taxes for that owner-manager.
Then there are many other potential adjustments, such as: salaries to non-working family members, lease payments for the owner's benefit, owner's personal auto expenses (lease, insurance, gas, repairs, etc.), charitable donations, reduction or addition to adjust rent paid to owner(s) to fair market value, owner's personal insurance (life, health, disability), retirement plan contributions, non-business meals and entertainment, non-business travel, non-business telephone and internet, and more.
And, buyers and sellers should both note that it works both ways. For example, if the owner-manager has a family member working in the business who is receiving no pay, or less-than-fair-market-value pay, then the amount a new owner will have to pay that replacement employee needs to be deducted from the SDE.
A proper calculation of SDE is vital to both seller and buyer. For example, a business showing a "profit" of $40,000 could easily have an actual SDE of $120,000; that's a huge difference in business value.An experienced business broker is the best resource for a thorough analysis of add-backs and SDE; and, the buyer's CPA should verify everything during due diligence.
I think a commonly overlooked method of verifying financial data is to ask questions, then verify with the financials. Sticking with the automotive example, a buyer could ask, "How much do you mark up your parts?" The seller will usually have a knee jerk, quick answer to this question, such as "We mark up all parts 30%" Then you can verify that in the financial data. If the financials show a 50 gross profit on parts, you know something is off. Maybe they are paying from another account to make the financials look better. Maybe they are using inventory for parts sales and not recognizing the inventory reduction and thereby overstating inventory and understating parts expense.
It's also important to verify key ratios versus industry standards. In automotive businesses, most professional shops, pay "flag time" so the mechanic is paid an amount equal to the amount of hours "the book" says it should take to complete that task. Whether it takes him more or less time, he is still paid the same amount and the customer is charged the book hours times the shops hourly rate. Therefore there shouldn't be wild fluctuations when it comes to mechanic labor costs, it should be a set percentage of Labor Sales, each and every month. If there is a fluctuation, the seller should have an explanation for it, such as hiring a new mechanic at a higher hourly pay rate or something similar. Seeking assistance from someone who owns or has owned a business similar to the one you are investigating is a smart move as well.