The first step in understanding the value of a small business is to discover what the true profits of the business are. This process is the cornerstone of all valuation models. It involves more than looking at the tax returns or the profit & loss statements.
Tax Returns and other Financial Statements do not always show the true “economic earnings" of a company. As a buyer or a seller you need to understand what the true economic earning actually is. Further study and analysis can reveal the "Owner's Benefit" also called the Owner’s Discretionary Earnings*.
The "Earnings" of a Business Enterprise Include:
- Net Profit (loss) before Taxes plus the following add-backs:
- Owner’s Total Compensation.
- Depreciation & Amortization.
- Interest Expense.
- Expenses that are unnecessary to the operation of the business (Perquisites).
- Income Taxes.
- Nonrecurring Expenses.
Owner’s Benefit Worksheet
The goal of the analysis, using our worksheet, is to determine the potential economic earnings of the business before tax decisions. Valuation is based on that Owner’s Benefit.
- Owners Records come from seller’s P&L’s OR Tax Returns.
- Adjustments are add-backs or subtractions to Operating Expenses.
- Reasons for each add-back are given.
- Adjusted Expenses column will provide a more accurate picture of expenses and help to compute the Owner’s Discretionary Income.
From Tax Return
Reason for Adjustments
Does her own
Used $1,000 to advertise personal rental property
Personal expense not needed for the business
Insurance - Business
Cleans office herself
Home AC repair
Tax - Payroll
Credit Card Charges
TOTAL ADJUSTED EXPENSES
Minus Total Expenses
Net Operating Income
Note that the profit shown on the seller’s P&L is $69,516, but after the adjustment are made to the Operating Expenses, the Owner’s Benefit is $117,643 and this amount more accurately shows the earnings of the business.
Minus Total Adjusted Expenses
* The term “Owner’s Discretionary Earning” has been defined by the International Business Brokers Association as a substitute for such terms as Owner’s Discretionary Cash, Owner’s Cash Flow, and Owner’s Benefit. These terms are not fully descriptive and have different meanings in accounting, financial, and appraisal professions.
The International Business Brokers Association states that the earnings of a business are to be based on the net operating income before taxes (from the tax return). The analyst will then add-back to the profit certain expenses that are tax related or are not necessary to operate the business. This then becomes the "Owner's Discretionary Earnings" and more accurately shows the earnings of the business.
For more information on the process or if you have questions, feel free to give me a call at 727-403-9933 or email me at firstname.lastname@example.org