If it's true, as commonly believed, that small business owners tend to be creative individuals, one of the expressions of this talent can be found in the way they calculate the adjusted net income or earnings they receive from their businesses.
Seasoned California business brokers often have difficulty coming up with an accurate earnings figure when analyzing the records of a company going on the market. Their challenge is to determine how much a new owner is likely to earn, based on the current level of gross revenues and the expenses actually needed to generate that income.
If accurately calculating the "bottom line" is hard for someone skilled in this field, imagine the difficulties faced by a real estate licensee with a background in home sales, who is called on to list a small California business opportunity for sale. It's easy to understand how real estate professionals lacking experience in analyzing businesses records, can be misled by a seller into advertising an exaggerated earnings figure for a business offering.
But the agent or broker will soon get an education--the hard way--about the importance of determining and stating the correct figures. That education will begin when the broker goes back to the seller for more information, after a buyer--relying on initial profit statements--discovers in due diligence that there is no way to substantiate the profits claimed.
The first thing for a new business broker to understand about an earnings statement is the calculation of Earnings Before Taxes, Interest, Depreciation and Amortization. The seller's books will probably show each of these T-I-D-A items as expenses, deducted from the gross profit figure along with other fixed costs, before conducting the final calculation of earnings.
An accepted accounting protocol is to assume that these TIDA expenses will vary, depending on the way each buyer wants to manage the financial side of his or her business. And because these "variable" expenses do not represent costs absolutely necessary to conduct business, the common practice is to add the TIDA expenses to the "bottom line" figure to arrive at the seller's earnings. And this figure should be properly explained as EBTIDA.
The cost of a legal settlement with a disgruntled former employee or with an unhappy customer who has some kind of claim, is an example of a non-recurring, or one-time expense. So is the cost of an expensive capital equipment item that was purchased from the business's ready cash in a single year. As these expenses are not going to be incurred by the new owner, it is fair, when analyzing the seller's Profit and Loss Statement, to add the amount of these non-recurring costs to the bottom line.
The buyer may have other one-time costs once the business has changed hands, and will treat them however he or she sees fit for bookkeeping purposes. But any non-recurring costs listed by the seller can legitimately be considered as if the dollar values associated with them are part of the seller's earnings.
It is common for the owner to have his company pay personal vehicle costs because he uses the car while conducting business, and for an owner to consider it the responsibility of the business to provide her with health insurance, and for an owner to carry a family member on the payroll, even though that person only does occasional, part-time work for the company. These represent business expenses which incidentally, also provide benefit to the owner. And as these are items charged to the business at the discretion of the owner, it is an accepted practice to assume a new owner will not incur the same expenses, and to add these costs to the seller's earnings figure.
Memberships in social/business organizations, such as country clubs and fraternal societies, subscriptions to periodicals and internet services, and other discretionary "business" costs might also be considered "add backs" when determining seller's earnings.
An inexperienced broker listing a business and wanting to enter an owner earnings figure that is correct, and can be logically explained, will benefit by carefully questioning the seller on each item "added back."
But there is no substitute for having worked with these expense entries in the past and knowing from experience, how to calculate seller's actual earnings.
About The Contributor: Peter Siegel, MBA is the Founder & Senior Advisor (ProBuy & ProSell Programs) at BizBen.com (established 1994, 8000+ CA businesses for sale, 500 new & refreshed postings/posts daily) working with buyers, business owners/sellers, business brokers, agents, investors, and advisors). Reach him direct at 925-785-3118 to discuss strategies regarding buying, selling, (or financing a puchase of) California businesses.
Categories: BizBen Blog Contributor, Business Valuation Issues, How To Buy A Business, How To Sell A Business
Comments Regarding This Blog Post
Contributor: Broker Specialist - MFG's, Southern CA
Whilst Depreciation and Amortization are normal addbacks to calculate either SDE or EBITDA, there are some occasions where CapEx can be an ongoing expense of the business. I had a case several years ago with a Concrete Sidewalk Installation company. They used Bobcat machines to break up the old sidewalks, before installing the new. These machines are typically depreciated over a seven year period, but in reality, required replacement every three years. In this case, the machines had to expenses over three years to reach an accurate net income level.
The difference between the "bottom line" and the REAL bottom line can be extraordinary. And, if the seller is not accurate in identifying every legitimate "add-back", he will leave a lot of value unrecognized. The experienced business broker is essential to that accurate analysis of the seller's finances and the proper presentation and explanation of the resulting "Seller's Discretionary Earnings" ("SDE") to prospective buyers. Furthermore, the primary benchmark for beginning the value of small businesses in the great majority of fields is the SDE; that's the basis for comparison to what buyers have paid for similar businesses.