Earnings Adjustments

Adjusting Financial Statements

It’s no secret that most business owners steer their ship with an eye on minimizing taxes.

You've probably thrown in some perks for yourself and the family, kept the kids on the payroll, and written off every possible expense through your business. And why not? They help in trimming down your earnings and, consequently, keeping your taxable income as low as possible.

However, when the time comes to value your business for a sale, your financial statements (the holy grail of business valuations) must be “normalized” or “adjusted.” It’s time to flip the objective on its head and aim for presenting your income as attractive as possible.  

Normalization is like giving your financial statements a makeover, making tweaks here and there so that your business's true earning capacity can shine through. It's all about stripping away the non-essential expenses, showing potential buyers the true cash flow that your business can generate from its operations.

After carefully making these adjustments, you will have arrived at what is known as seller’s discretionary earnings (SDE) or earnings before interest, tax, depreciation, and amortization (EBITDA).

• SDE is the most common metric used by buyers, business brokers, and many other professionals for valuing companies with annual revenue of a few million dollars or less.
• EBITDA is the most common metric used for valuing businesses with more than $5 million in annual revenue.

For purposes of this article, we’ll refer to them as simply, “earnings”. Therefore, adjusting your financial statements is one of the most important steps in preparing your business for sale. If you don’t do this correctly, you could be leaving tens of thousands of dollars on the table.

Types of Adjustments

In general, add backs (another term for adjustments) fall into one of the following categories: discretionary, non-operating, and non-recurring adjustments. These adjustments will vary from company to company, but understanding these major categories is helpful in identifying potential increases to EBITDA/SDE, and thus business value.

• Discretionary: Discretionary add backs are expenses that don't necessarily play a big role in how the company operates or are unlikely to stick around under new ownership. Think above-market owner compensation, jet-setting on the company dime, sports tickets, etc. When adjusting for these, don’t forget to consider payroll taxes, insurance, and benefits related to any excess wages.
• Non-operating: As with the discretionary add backs, non-operating add backs are expenses that are not required in or related to the true operating performance of the company. Oftentimes, these are related to non-operating assets, such as real estate costs, or liabilities, such as loan payments.
• Non-recurring: Non-recurring add backs are expenses which could be related to the business but are unlikely to occur again in the future. Examples of non-recurring expenses may include legal expenses, one-time consulting or other professional fees, facility relocation expenses, bad debt expense, and donations, among others. 

‍

Common Adjustments 

1. Lifestyle expenses - luxury cars and family vacations deducted as a business expense negatively impact your company’s earnings profile, so adding them back will increase your earnings.

2. Owner salary and bonuses – The business owner’s compensation rarely matches what a hired executive would be paid. In most cases, it is higher, but in other cases it is lower. Either way, it needs to be adjusted to a reasonable level of compensation as part of normalizing earnings. Additionally, for sub-$3 million revenue businesses, the entire owner’s compensation is usually added back to earnings. This is because a business of this size is typically owner-operated and so we want to show the total cash flow compensation that will be available for a future buyer.

3. Family members’ wages and benefits. Don’t forget family members on payroll. Many business owners use family members to shift income and/or provide employment and benefits to loved ones at above-market wages. Unless the family member will continue in their current position with the same salary and/or will not be replaced with another for a similar wage, the salaries and benefit costs should be added back to the earnings.

4. Start-up costs and one-time expenses. If a major one-time expense was incurred within the last three years—a typical window of time analyzed by potential buyers and their lenders—, those costs should most likely be added back to earnings because it’s unlikely they will occur going forward.

5. Lawsuits and professional fees. Any expense related to a lawsuit or other non-recurring legal dues should be added back to earnings. Don’t forget consultants, business coaches, and other advisors hired for projects that are unrelated to the continuing operations of the company.

6. Adjust rents to fair market value. Many business owners buy buildings and then lease them to their companies at rents that may be above or below fair market value. These expenses should be normalized to fair market value for your area and industry.

7. Repairs and maintenance. Business owners will often list capital expenditures – purchases that will serve the business for greater than 1 year – as repairs. While that is a good way to minimize tax liability, it is a major hit to your bottom line, and you’ll be leaving value on the table if do not add these back as well. 

Here are some more common adjustments you might want to consider:

Other Common Adjustments

• Depreciation
• Amortization
• Interest payments on any business loans
• Non-operating revenue, like interest income or the sale of an asset (assuming you are not in the business of selling such assets)

Additional Considerations

Remember to be thorough and make sure that all adjustments are verifiable. The more thorough and accurate your documentation, the better. If you're a bit heavy-handed or off the mark with one adjustment, most buyers will question the credibility of everything you say from that point on. This is why we recommend you hire an expert to guide you in making these adjustments. Remember that, as a seller, your goal is to maximize your adjusted earnings (EBITDA or SDE) to make your total business value to be as strong as it can be.