Add Backs: Defining Adjusted Net Income When Buying A Small Business


Adjusted Net Income Add Backs Analysis

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 income 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 (or tax returns) and financials of a company being considered, but does some investigating to learn what the figures actually represent.

Some typical "add-backs" utilized frequently to compute adjusted net income/sellers discretionary cash/cash flow include:

- Owner's Annual Salary
- Annual Net Income
- Owners Pension
- Owners Health Insurance Premium
- Amortization
- Depreciation
- Interest Expense (typical are loans that will be paid off when the business is acquired)
- Rent/Mortgage Payment (if the business is being acquired with an SBA Loan)
- One Time Business Expense (an annual expense the new owner will not have in the future)
- Salary Expense Of Family Members (who don't actually work at the business)

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!

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

Contributor:

Peter Siegel, MBA
Areas Served: All Of California
Phone:  925-785-3118 Cell, 925-785-3118 Text
Founder Of BizBen.com (since 1994). I am the Lead Advisor for the ProSell, ProBuy, & ProIntermediary Programs. I consult daily with buyers, sellers, and brokers daily about buying and selling California small to mid-sized businesses. Call 925-785-3118.

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.






  Helpful Resources To Assist In Selling And Buying California Businesses
Helen Yoo, New Century Escrow - Escrow Services In Southern California

New Century Escrow, Inc. is a fully licensed & bonded independent escrow company. Over 20 years combined experience in handling bulk escrow transactions. Multi-lingual staff that speaks your language, including Korean, Chinese, Vietnamese. Call Helen Yoo direct at 626-890-1151.

Brad Steinberg, Business Broker: Laundromat Specialist

PWS is the leading laundromat broker in California. Since 1968 PWS has brokered over 2,500 laundromat sales. With over 90 employees dedicated to the coin laundry industry, PWS has 18 licensed agents, a 3 person in-house finance department, 10 service technicians and a 20 person parts department.

Elizabeth McGovern: Escrow Services - San Francisco Bay Area

McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.

Diane Boudreau-Tschetter: Escrow & Bulk Sale Services - CA

California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.

Shalonda Chappel: Escrow & Bulk Sale Services - Southern California

Escrow services to brokers/agents, sellers, & buyers. Established 43 years. Extraordinary service. Experienced with handling difficult transactions. One stop for all your escrow needs: Bulk sales, lien searches, UCC searches, liquor license transfers, publishing & recording services. 951-808-3972.

William F. Ziprick, Attorney: Legal Services For Buyers And Sellers

Through creative problem solving, attention to detail, accessibility, & understanding that unnecessary delay is often a deal killer, I work closely with my clients and other professionals to consistently achieve a high rate of closings. Office: 909-255-8353, Cell: 509-951-7230.


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