Business Valuation - Recasting the Financials

Recasting of financials or profit and loss statement is one of the primary steps that go into valuing a small to mid-size business. It is also one of the primary services a business broker or mergers and acquisitions specialist will provide when determining the value of a business.

Two Types of Financial Review

Basically there are two types of financial review for small business operators: Financial accounting for minimizing tax liabilities and financial accounting for determining the value of a business.

Companies track of their financial performance by use of balance sheets, profit and loss statements, and tax returns. Reporting financials this way is necessary for accounting and tax purposes and for understanding the "health" of a business but it is not really useful when it comes to determining the fair market value of a business and its true financial earning power for a new owner.

For example a small to mid-size businesses P&L statement might be accurate for a new owner, but the balance sheet will be completely different. A new buyer will almost always bring in new financing and have different types of debt and assets, therefore the traditional way of analyzing a business from an accounting perspective will not give an accurate picture to a new buyer without being "recasted" accordingly to arrive at the "True Owner's Benefit".

To simplify further the current owner might have a $200,000 bank loan on his balance sheet. A buyer might pay all cash for the business, thus eliminating the loan and having a completely different balance sheet.

Seller's Discretionary Earnings

The true owners benefit is what we call the Seller's Discretionary Earnings. This will be the Net Income on the P&L statement or tax returns with various discretionary expenses added back into that net income.

A business owners compensation, bonuses, incentives, personal loans and other discretionary expenses are all common areas that might be added back into the net income when recasting financials.

These discretionary expenses are "added back" into the net income of the business so that a prospective buyer can accurately assess the businesses ability to generate profit. The owner has to see enough cash flow to pay himself a fair market salary and also cover any debt service for loans he may take on to acquire the business.

For example let's take a business owner that is asking $300,000 for his business. His net income on his prior year's tax return is $25,000. It is very clear, based on the net income that a new owner will be hard pressed to pay any debt service on a loan with only $25,000, let alone draw a salary. If the buyer pays all cash for the business it will take 12 years in this case to break even, again, before drawing a salary.

After reviewing the seller's financials we see that the owner "writes-off" the following discretionary expenses on the prior year's tax returns:

-Owners Compensation - $75,000
-Owners Health Insurance - $6,000
-Owners Car Lease - $4,200
-Business-related travel - $3,000

These are legitimate business expenses/write-offs as far as the IRS is concerned, thus leaving $25,000 in taxable business income.

Adding up these discretionary expenses we come up with a total of $88,200 in discretionary expenses. These expenses represent cash that a new owner would have but may choose to use in another way. A new owner may not spend $3,000 a year on work related travel and may not choose to pay for health insurance though the business and may not choose to pay himself $75,000.

If you add the total discretionary expenses to the net income we now have a "Sellers Discretionary Earnings" of $113,200 for the prior year. This figure is the true amount of cash that the seller realized during the prior year.

Now we can see if the buyer pays the asking price of $300,000, all cash, it will take roughly 2.65 years to break even - a much more reasonable time, compared to 12 years.

We can also quickly see that with a reasonable down payment that there is enough cash flow to pay a bank note and still have money left over for a new owner to earn a salary.

Much goes into the overall process of determining value and selling a business, but recasting the financial statements of a business will give a good indication of financial expectations of a particular business.

Jason Pittman is a Business Broker and intermediary in Chicago, IL.

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