Adjusting Financial Statements - Overview

Most business owners minimize taxable income by eliminating expenses that are not directly related to the business’s operations. These expenses might cover personal auto, insurance, cellphone, child care, medical care, travel, among others. For this reason, adjusting the financial statements by “adding back” these expenses is often necessary to show potential owners the actual cash flow available.

Adjusting the financials allows us to compare your business to other businesses using seller’s discretionary earnings (SDE), also referred to as seller’s discretionary cash flow (SDCF), adjusted cash flow, owner benefit, recast earnings or normalized earnings.

Among all these terms, SDE is the most common metric used by business brokers and many other professionals, including buyers.

Seller’s Discretionary Earnings or SDE is defined by the International Business Broker’s Association (IBBA) as:
  • Pre-tax net income (the bottom line profit that appears on profit and loss statements); plus

  • Owner’s compensation paid to all owners, less the cost needed to replace a second or third owner; plus

  • Interest expense; plus

  • Depreciation and amortization; plus

  • Discretionary expenses (auto, cellphone, meals, entertainment, travel, etc.); plus

  • Adjustments for extraordinary , non-operating revenue or expenses , non-recurring expenses or revenue (lawsuit, flood damage, etc.)

Example

Pre-Tax Net Income

$100,000

Owner's Compensation

$100,000

Interest

Due diligence is the process of investigating a business prior to purchasing it. When a buyer makes an offer on your business, there is a period of time that follows where he or she researches your business and further investigates the situation. This period of time typically lasts 2-8 weeks (approximately 30 days for smaller deals and 30-60 days for larger deals)and is called “due diligence.” However, it is also important that you, the seller, perform your own due diligence. By doing this, you will discover red flags and be able to fix problems in your business before a buyer can discover them. Here are four tips that you should read before listing your business for sale.

1. Perform your own due diligence properly.

As a seller, performing due diligence can mean the difference between attracting the right buyer and having your business sit on the market. The market is fickle and sellers who perform due diligence properly are the ones with the competitive edge.

2. Do not procrastinate.

Business owners looking to sell their businesses often ask “when do I start due diligence” and the easy answer is, the sooner the better. Inexperienced business owners do not understand how involved the process can be and unfortunately, many business owners postpone this process too long and then rely on the buyer’s due diligence. While you may still get your business sold by doing this, you can sell your business for more money and faster by

It is never easy to emotionally detach yourself from matters that are very important to you, and your business is no exception. It is akin to evaluating your child as a neutral third party would; realistically, you cannot. And it makes sense why; you have likely invested numerous hours and many resources into your business. And, really, what is the harm in thinking well of your business or of bragging about it?

Generally, there is nothing wrong with playing favorites with your business. However, this favoritism can lead to one major downfall: over-valuing your business. Like the parent who thinks her kid can do no wrong, business owners often overlook the flaws in their own businesses. This becomes a problem at two major times:

1. When the business is not profitable

There are business owners out there who do not have a grasp on how their business is actually doing. We have heard from owners who are struggling to make a profit but do not know what they are doing wrong. This is when wearing rose colored glasses can hurt your business; you are not able to see the true problems. And you cannot fix problems you do not know exist. So, what can you do as a business owner do determine how your business is truly doing?

  • Consider hiring outside help; be it from a consultant, CPA, accountant or an attorney.
  • Set up a survey to get customers’ opinions on your business.
  • Ask your employees for honest feedback about the problems of your business.
Discounted Cash Flow valuation is the core tool in valuing a company used by Investment Bankers and Equity Analysts. The cost approach to valuation fails to capture many of the intangible assets for small business whereby reputation, managerial expertise, and other items do not show up on the balance sheet. The use of price multiples is not applicable in most cases because of the large variations of types of businesses, limited data, and the uniqueness of the business at hand.

The income approach is the dominant approach in business valuation. The discounted cash flow method captures the driving principle of a valuation: value is the present worth of future benefits. Value today equals cash flow discounted at the cost of capital. Discounted cash flow is the most commonly used method of valuation in corporate finance today. It arrives at an estimate of what one would pay today for a series of future economic streams.

The cost of capital is also known as the discount rate. It is the expected rate of return for similar investments. Discounting is, in effect, the exact opposite of compounding. To find the discount rate, take an expected payment at a point in time and compound the value backwards at the expected rate of return. The present values of each increment (year) add up to provide the current valuation. A capitalization concept is used in the final year. In capitalizing, the expected future income is converted into a value. Instead of projecting returns into perpetuity, choose a final year (called a Terminal Year) and capitalize that year’s cash flows by a factor (the discount rate less the expected long-term growth rate). Then, compute the

A venture capitalist is a person, or even an organization, that invests money in a business in exchange for a share of the company. Most of you have probably seen the show Shark Tank, where people from all over present their business or idea to the Sharks in hopes that one will invest some money into their business, either to get the business started or to help it expand. In exchange for a monetary investment, and often their connections and knowledge in the industry, the investor will want a percentage of ownership in the business. The Sharks on Shark Tank are not the only venture capitalists out there, there are plenty others looking for a great business or idea to invest their money in. Here are five ways to attract a venture capitalist:

1. Plan. Plan. Plan!

Having a solid plan is crucial to attracting a venture capitalist. Plan, in detail, how you will operate the business, how you will distribute your product or service, how you will manage your finances, and so on. If you already have an established business, even if it seems to be running smoothly, make sure you can clearly articulate how your business operates and your plan for the business, now and in the future, to a potential venture capitalist.

2. Have a strong team.

Make sure all of your employees have defined roles and execute them seamlessly. Nothing will turn away a venture capital faster than a weak team. Your employees, believe it or not, define your business. Many new business owners cannot afford to pay employees and, therefore, family is often tasked with running the business. However, if cousin Johnny is in charge of your finances and aunt