Evaluating the earnings potential of a small-to-medium sized business, particularly one with a single owner, is challenging. Often, a primary objective of these entrepreneurs is to make as much money as they can, while paying as little in taxes as possible.
Accountants routinely assist business owners to help accomplish the goal of minimizing taxes. But, to truly understand the value of the business and accurately project future cash flow, it is important to look beyond the tax returns to realize how the money is being spent.
When considering a potential acquisition, a first step is to determine a business’s cash flow by “recasting” the financials. Recasting financials is a fancy term for adjusting them to provide a more accurate picture of what the business is truly producing with regard to cash flow. This process looks for items that are ‘fringe benefits’ or owner’s-lifestyle expenditures and then adds them back to determine true cash flow from operations.
Consider these examples listed below:
Paying for health insurance coverage, cell phones plans, vehicles, and travel expenses for family members are often shown as expenses to the business. Some of the items could be a combination of both personal and business expenses so it is important to understand what portion should be considered personal use and add back only that amount.
Often business owners donate to a particular charity. The motivation for these donations vary. It could be a cause he/she wants to support, or it could be that there are certain business relationships that will be enhanced because of the involvement. It is important to determine what is truly discretionary and would not affect business prospects if they are not continued. Other discretionary spending to review would include legal fees for family-related matters, or season tickets to a local sporting venue. A new owner may choose not to spend money on these activities if the business value is limited.
Another major add-back can be the one-time, non-recurring or extraordinary expense. A good example would be hiring a consultant to re-vamp the workflow process in a manufacturing plant. Once completed, this expense will most likely not be required in the future. By adding back such items, we have a more accurate picture of the normalized cash flow.
By adding back the owner’s, or the salary given to other family members, the new owner can better determine the appropriate salary level for the business model he/she intends to use to run the business.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This is the most widely-accepted indicator of a business’ profitability and any potential business buyer should be familiar with the term.
In most cases, the add-backs that have been identified as discussed above would be added to EBITDA, resulting in what is called Owner’s Discretionary Earnings, or Adjusted EBITDA. This number provides a clearer view of cash flow to use as part of the business evaluation process, as well as a critical starting point for making business decisions once the purchase has been completed.