Differences Between Adjusted Net Income, Cash Flow, EBIDTA, etc.

The profit and loss statement ("P&L") will show total revenue from sales and other sources and will then deduct the cost of goods sold ("COGS") or cost of sales ("COS")--raw materials, production labor, manufacturing or service delivery expenses--directly related to the product or service to find the Gross Profit. From the Gross Profit is deducted all general and administrative ("G&A") expenses--such as rent, travel, insurance, officer's and manager's salaries, utilities, advertising, etc.--all for the general administration of the company unrelated to a specific product or service. After deducting these G&A expenses, we arrive at Net Profit or Net Income--the Earnings Before deduction of Interest and Taxes (EBIT) or the Earnings Before deduction of Interest, Taxes, Depreciation, and Amortization (EBITDA). When we deduct the EBIT or EBITDA, we arrive at the Adjusted Net Income. You can think of EBIT as the calculation of cash flow and EBITDA as cash flow less deductions not requiring a cash outlay depreciation and amortization.

Cash flow can be defined as the difference between the cash available at the beginning of an accounting period (month, quarter, year) and the cash available at the end. Cash flows in from sales, loans, investments, and asset sales, and flows out to pay operating expenses, loans, and asset purchases. So, cash flow is similar to but different from the net profit or loss shown on a P&L.

For purposes of buying or selling a business, cash flow and seller's discretionary earnings ("SDE") are the most important metrics. Cash flow shows just how liquid the business is and how well it can be sustained with existing revenues and existing expenses. SDE, though provides the rest of the story. When buying a business, we generally are looking for what the seller truly realizes out of the business. This can be a complicated calculation that business brokers have developed certain expertise in making. Generally, you would take the net profit (or loss) and add to it interest paid, depreciation taken, and discretionary expenses run through the company personal cell phone, personal automobile use, insurance for the benefit of the owner, business travel with a particularly personal benefit, etc., etc. In the case of a business generally under a million dollars or under 10-12 employees, usually the SDE includes the wages paid to one owner/manager, and all the taxes and fees the business paid on those wages.

For almost all business categories there are "rules of thumb" of multiples of SDE to place a range of value on a business. This is just one factor, but a very important on in determining market value. For example, dine-in restaurants typically sell within a range of 1.8 to 2.3 times SDE. This, of course can vary considerably based on many other factors; but, it does illustrate why a clear understanding of not just cash flow but also actual SDE is essential for a successful business sale or purchase.

ADJUSTED NET INCOME, To determine an value of a business as it compares to others certain expenses are pulled from the P && L that may otherwise distort the comparable value of one business over the other. The EBIDTA describes some of this. These costs may change from business to another. Other add backs may apply. A for instance would be a situation where two like businesses are operated differently by choice. Example, one business is absentee operated and the other is self operated. Is the savings of patrol by self operating the business more profitable? You must add back the patrol not spent in order to compare the two fairly. However, other related advantages may add value.

CASH FLOW, concerns itself primarily with the liquidity of the business. The ability of the business to pay its bills with the continuing flow of cash. This is a good area to look for seasonal or other adjustments and prepare for it. A business with a steady cash flow will tend to be easier to manage as compared to a business that depends on larger periodic sales.

EBIDTA, which is an acronym for Earnings Before Interest, Depreciation, Taxes and Amortization are specific areas that are typically added back to the net income to evaluate the business.

Adjusted net income is a number frequently used by business sellers who have discretionary expenses that a new buyer won't have. For example, a seller paying for a luxury car through their business when that expense is not required to operate the business may, "add back" the expense to come up with an adjusted net. Adjusted net reflects what a new buyer, who presumably won't have the same expenses, would net from the business. Small businesses are frequently valued at a multiple of adjusted net.

EBITDA is "earnings before interest, taxes, depreciation, and amortization". It's typically used as a benchmark and/or base on which a multiplier can be used to determine a business value. It can be helpful to equalize an analysis of the performance of two businesses in the same industry which may have different debt structures or different accounting histories with respect to how they depreciate or amortize capital expenditures.

Cash Flow is defined as net income after taxes, plus non-cash charges such as depreciation and amortization. It is typically used to determine a business' financial health and its ability to continue have enough cash on hand to fund business operations. Cash flow differs from Adjust Net and EBITDA in that it measures the flow of cash into and out of a business rather than just profits, which may exist only on paper.

Cash Flow: Generally this is the amount of money that is shown at the bottom of the Profit & Loss statement or the Net Income line on your Federal Tax Return. Usually this number is not used in reference to the sale of a business.

Adjusted Net Income/ Adjusted Cash Flow/Seller s Discretionary Earnings (SDE): These three terms are used synonymously. You take the net income or cash flow and then add back the amounts expensed for the following: (1) Corporation Taxes (2) Depreciation, (3) Amortization), (4) Interest (except for amounts for debt that is being transferred or amounts for capitalized leases), (5) all owner compensation and President s compensation if owner is not working full time, (6) other personal benefits to the owner/President, (7) all personal expenses that were not required for business. The resulting amount is what a Full Time Working Owner who purchases the business with all cash would have at their disposal.

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization): This is the amount arrived by taking the net income and adding back (1) Corporation Taxes (2) Depreciation, (3) Amortization), (4) Interest (except for amounts for debt that is being transferred or amounts for capitalized leases). This assumes a reasonable compensation for a President/owner. So if the compensation is high then it a portion should be added back. If the compensation is low then the difference between what a reasonable salary for a President would be and the current compensation should be subtracted. The resulting amount is the EBITDA. Many cases the other personal benefits that are unusual or other non-business expenses are also added back.

Generally EBITDA is used for larger companies making significant revenue and profit and the Adjusted Net Income or SDE is used for smaller companies.

When looking for the possible sale prices in various databases, you might see the price as a multiple of EBITDA or as a multiple of SDE. So it is important to use the correct multiple with the amount you have calculated (EBITDA or SDE).

These are all utilized by Brokers and Sellers to relate what the benefit is to the Seller from owning the Company. Usually for smaller operations, adjusted net and cash flow are used, there's no rhyme or reason really, but I would say it's safe to say a business generating in the neighborhood of $450-$500k would usually be reported in terms of adjusted net income or cash flow.

Once you're above $500k I find it more and more likely you would see EBITDA.

I received an email a few months ago asking a similar question.

I am researching a company to purchase and having difficulty understanding Owner Benefits. If an owner takes a reasonable salary, why is this considered an Owner Benefit and added back into the Adjusted Net Income? If the owner did not take this, the work would still have to be done by another person and then it would be listed as a payroll expense for another employee, thereby deducted from Adjusted Net Income. I can see if it said the salary was above and beyond market rate, but not if it is a fair market salary and required as a function of the business... Your insight is greatly appreciated!!

The profit figure you are looking for is called the EBITDA (Earning before deducting Interest, depreciation, taxes and amortization) This figure is similar to Owners Benefits except that a Fair Market Value Salary for the working owner has been deducted from the profit. Corporate America uses EBITDA because the manager usually does not own the company and as you have said, he must be paid before the stockholders can take a dividend.

Owner s Benefits (sometimes called Adjusted Net Income) is designed for small main street businesses where the owner is working to make a living to support his family. He did not buy it as an investment or to be an absentee owner, but to work the business for money he can earn for his time and investment together. If he hired a manager the business may not make any profit at all or a profit so small it is not worth owning. These types of businesses are not designed for investment but to be owner operate. All profits of a small business accrue to the owner regardless of how labeled. The owner is buying the business and working it to make a living. A second family member working for free is not part of the Owner s Benefits. The fair market value of the wages of the second working family member must be deducted as an expense. The Owner s Benefit formula only allows one non-paid working owner, time to be included in the calculation. If two people were allowed to do this the ability to compare businesses would be impossible since some would have two free workers and others would only have one.

That being said lets clarify a few other points on this subject. Even through sellers do pay interest and taxes and have some real depreciating assets, these items are not deducted for purposes of determining the Owners Benefit or the EBITDA. That is because each person will have different numbers for each of these items and consistency is needed for comparison purposes.

Cash flow means different things to different people. It is supposed to be the amount of profit that the owner has to spend after he pays the business expenses. I define it as being the same as the Owners Benefits, SDE or Adjusted Net Income. Others may think it means something else. Get an exact definition when the term is being used.

I think I should also point out that if you are looking at an Owners Benefit number of $100,000, for example, that is enough to cover a salary of $50,000 and the balance as a profit from operations. The value of this business might be $150,000 to $200,000 based paying two times the business profit or Owner s Benefit.

If you looked at EBITDA for this business it would be $50,000, based on this number a seller might ask $200,000. This is based on an assumption that a buyer will make a 25% profit on his investment and nothing for his time, since that is covered by the manager s salary.

Depending on how you look at a business and why you are buying it should determine if you calculate the EBITDA or the Owner s Benefit.