In order to find the accurate valuation of your business, you need a normalized EBITDA. That’s where recasting financial statements come in. It is used to help calculate the value of your business and is often referred to as normalizing or recasting your financial statements.
You’ve likely heard the term EBITDA tossed around before. EBITDA is an acronym which stands for Earnings Before Interest Taxes Depreciation and Amortization. So, we also need to talk about EBITDA in this article because it’s important for determining if your profit and loss (P&L) statement is or isn’t out of whack.
In the past, I have seen business owners pulling hundreds of thousands of dollars out of their business in the form of various perks. They’ve worked hard to reach ‘success’ and feel their efforts are finally starting to pay off. I’m not here to debate whether it is wise for the P&L statement to reflect large personal benefits for the business owner. More than likely in this scenario the owner is taking an above-market draw (including business perks) from the company, but they have every right to do so. They own it. Here’s where it gets murky. If you were to hire a manager to do the same job the owner is doing, it is not very likely they would get paid nearly as much. Perhaps the market pay would really only warrant a salary that is about 1/3 of what the owner is taking. So, when we are dealing with recasting the statement for EBITDA, we have to bring the business owner’s salary back down to the current market rates.
Another factor to consider in relation to normalization is the rent expense. Many times a business owner will own the real estate in which the business actually rents. In other words, they are paying themselves rent. Because of the way the tax code is written this is often a perfectly legitimate transaction. However, the owner increases the rent to a little higher than the fair market value to put more money back in their own pocket. When we recast the financial statement, we have to normalize the rent and make sure it is in line with market conditions at that time.
The next area to look at is discretionary expenses. Perhaps the owner is utilizing a second home for entertaining purposes when it comes to their business; this would fall into that category. While doing so may be a legitimate expense based on the tax code, it may not be something the business would purchase if a manager were overseeing the owner’s duties.
Here’s the thing, for a buyer to want to buy your business, these expenses need to be in line with other similar businesses. The buyer may not want your second home or boats or cars or whatever as expenses on his books. These various expenditures all fall under discretionary expenses, so we add these numbers back to the EBITDA. The new owners/buyers probably aren’t going extend the same perks of luxury to a manager that the owner would take. So basically whatever discretionary expenses you have on your P&L, we want to put those back whenever we are recasting the financial statement.
Additionally, you’ll want to add back in any one-time charges you incur. For example, maybe you settled a lawsuit, or maybe you bought an asset that you wrote off. In these cases, you need to add back or maybe even subtract from the earnings when recasting the EBITDA statement.
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Let me give you a real-life example of why recasting for EBITDA is so crucial to your business. For this particular case, the net income of the company looks like it is $100k on my client’s income statement. He has many various expenses on the P&L. After we normalized and dealt with his salary, the discretionary expenses, and one-time charges, the recast EBITDA for him ended up being almost $400K. That’s a HUGE difference! Many times, business owners will look and simply state their business is worth whatever the value the tax forms or balance sheet says. When in actuality, that is not what their business is worth.
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When a buyer comes, they are looking at the business from an investment standpoint. They want to see what the company is worth, not how you used the tax code to your advantage. The buyer is asking questions like, “How can I normalize this business? Or how much profit will I make after I normalize this business? Is buying this business going to give me a good return on my investment?” So it’s vital to recast your EBITDA when the time comes to sell you your business. You want to be able to give the buyer the real earnings versus the reduced number. The only way to do that is to recast your financial statement.
To learn more about valuation and growth, visit our Building a Sellable Business series with topics that make your company more attractive to the business-buyers when you are ready to sell.