Adjusted Net Income

Adjusted net income (also referred to as cash flow, and sellers discretionary income) is the amount of money an owner actually receives from his or her business, a figure that may be substantially different from the net income - also called profit or net earnings - shown on the profit and loss statement for the business. The difference results from adjustments made to net income shown on the books, in order to demonstrate actual earnings to prospective buyers of the business.

The adjustment is necessary because most business owners take advantage of tax laws to minimize the amount shown on the business’s "bottom line." They seek to show minimal net income in order to pay minimal income taxes. This is legal if done properly, and applies to a business entity whether a sole proprietorship, partnership or corporation.

When the owner wants to sell, the fact that minimal net income is reflected in the business books can be a problem because the value of the business - that is, the price the seller can expect to receive for the business--is based largely on its net income. How does the business owner show minimal income to enjoy low tax exposure, but when it’s time to sell, can claim that earnings actually are greater than the figures shown on the books, in order to boost the value, and sale price? That contradiction is resolved by adjusting or "restating" earnings shown, by adding back, to the net income figure, the business expenses that were claimed on the books submitted with tax returns.

Some of the "add backs" a buyer can expect to see after net earnings have been adjusted, include non-cash expenses such as depreciation and amortization. The IRS allows deductions for these "business expenses" even though the amounts listed are not spent and can be withdrawn by the owner for personal use. Other business expenses that can be added back are those incurred under the present ownership, but might not be charged to the business with a new owner. These include interest payments charged to the business on loans taken out to purchase the business, and the amount of income taxes paid, which - as explained here--are a function of the way the owner chooses to adjust net income declared.

Personal expenses, such as health and auto insurance premiums, vehicle expenses, travel and entertainment costs, may be shown as business expenses, although not necessarily needed to operate the business.

Adjusted Net can also be called Sellers Discretionary Earnings or SDE. SDE takes the financial statements under the current owner and adjusts them by removing income or expenses that would not normally occur in the running of the business or making sure if an income or expense item is part of the business its at normal or market rates.

For example, if the owner of the business is going through a divorce and puts the cost of paying the attorney through the business, that's a cost that is not normal and needs to be added back or adjusted.

Another example. If the owner of the business also owns the real estate but doesn't have a cost for rent on the Profit and Loss Statement, this needs to added and therefore bring the business costs in line with a normal situation.

Similarly, using the last example. If the owner of the business shows a rent above or below market rates, it would need to be adjusted so the financial statements are relevant and accurate.

This methodology is also used by business appraisers and SBA lenders.

The term Adjusted Net Income is a term used to describe the results of a process, which includes adding or removing income, and cost items that do not adequately reflect the operation being transferred. The need for the Adjusted Net Income is important in order to get as close as possible to an Apple-to-Apple comparison. Items associated with EBIDTA are also typical of Add Backs that lead to the Adjusted Net Income. However, all adjustments should be disclosed and interpreted.

Many businesses incur expenses currently that a new buyer would not necessarily incur. Adjusted Net Income (or "Adjusted Net" as its often called) backs those expenses out of the business' profit and loss statement to provide a more accurate picture of the true net income a new buyer would have when they buy the business, given the same gross income.

For example, a business owner may drive a luxury vehicle, have a life insurance policy, or take trips tangentially related to the business, all of which may be currently expensed through the business. A new buyer would presumably not have those same expenses, and adjusted net takes that into account. A seller would typically "add back" to income all of those expenses to come up with the adjusted net income. Other expenses that are frequently added back to arrive at an adjusted net include debt service on loans or credit cards (which would presumably be paid off before a sale, or not included in an asset purchase), as well as prior expenses no longer being incurred, or one-time expenses that won't occur again in the ordinary course of business. Buyers should be cautious to investigate that any add backs are truly "seller discretionary" items, or otherwise truly not needed for the business to operate as it does currently. Sellers should be cautious when stating adjusted net income to not add back expenses when the impact on the operations of the business if those expenses are discontinued is not clear.

The adjusted net income or adjust net profit is the income that it makes that it makes, adjusted to reflect certain company practices and excluding any one-time or unusual items (income or expense). Each year you prepare your financial statements (P&L) reflecting the amount of profit (or loss) that you realized. Since each business and each owner is unique, this net profit (or loss) may not represent what a buyer would expect if ownership changed. These changes are adjustments to the net income/net profit and result in the adjusted net income.

For example, an owner may pay himself a salary below the market, making the profit look higher—this would require an adjustment to reduce the net income. Or, the seller may employ a relative at a much higher-than-market rate, or pay "gray area" personal items through the company (cell phone, car, personal insurance, etc.); these would require that the net income be increased—adjusted higher.