A common question that I get asked by those that are not experienced in the acquisition of small and mid-size businesses is “What are recast financials and why would you recast them?” Well, while the process can be fairly intricate, the concept and purpose is rather straightforward.
In a small to mid-size privately held business it is common for the owner and his/her CPA to work diligently to be as “tax-efficient” as possible. Proactive owners will most likely pay themselves a salary, expense any item that could be remotely justified as a business expense, work with their CPA at the end of the tax year to determine if there are any one time expenditures that could be made that would benefit the business (and the owner) with the purpose of ensuring they are as tax efficient as possible. They may also take advantage of adjusting inventory methods, accelerated depreciation and amortization of intangible assets to reduce the tax burden on the owner. In a nutshell, the goal of an owner and their CPA is to take every advantage within the limits of the tax code to make sure the bottom line (ordinary business income/loss) on the tax return is as small as possible.
So, what does that mean for a buyer? How do you evaluate a business’s worth based on the reported profitability when this number could be skewed drastically based on any number of factors. Does the business that has a better CPA get penalized in overall value because it took better advantage of tax breaks and strategies to reduce it’s tax burden? Does the company that has purchased newer and better equipment recently and taken advantage of accelerated depreciation methods (reducing the bottom line) end up worth less than the business that is running older, potentially outdated equipment that is already fully depreciated? These are difficult questions to answer based on just this limited information, but in most cases the answer would seem to be no.
So, how do you determine the worth of one business relative to another? Well, as in valuing most things, you try and find a way to compare “apples to apples” as they say. In other words, you must answer the question “What type of income does this business generate if you look only at the income it generates (not income as it is paid) in a given time period from the sale of products or services, and the actual necessary operating expenses of the business that are incurred in the production and delivery of those products or services?” The first thing to do is to determine what revenues were generated in a given time period. If the accounting and book keeping systems are kept on an “accrual” basis, then this is already reflected in the numbers. If it is not, you must adjust the revenues to reflect the sales that were generated in that time period (not the actual cash that was paid for products or services that may have been delivered in the previous year). Consider a business that receives payment for their product or service 90 days after it is delivered to the customer and does their book keeping on a cash basis. If the business grew the first 3 quarters of the year and then the last quarter of the year revenue generating activities fell drastically it would look like the business was extremely profitable that year. The revenues reported on the financials for the fourth quarter would be for products or services delivered in the 3rd quarter, making it seem as if the revenues grew higher than all of the previous 3 quarters. In addition, the expenses would have likely fallen dramatically as there would be less expense associated with delivering as much product or services in that 4th quarter. This could lead to a misleading overstatement of profitability in that year.
Next, you must strip all of the “fluff” as I like to call it from the expenses. Some of these numbers are easy to determine as they are line items on the tax return or are included on the supporting statements. These items include Depreciation, Amortization, Owner’s Compensation, and Interest (as interest is a cost of capital to the owner and not an operating expense of the business). Some of them, however, can be a little more difficult to find as they are hidden as parts of other line items within the return. An extensive and detailed interview with the owner and preferably his or her CPA would be ideal to isolate any of these one-time or non-operating, unnecessary expenses.
There are many different formats that brokers may use to illustrate these adjustments. The goal is to make sure that a buyer can see an itemized list of the adjustments you have made and the resulting adjusted values for each line item from the return, as well as the total amount of adjustments made and the resulting adjusted cash flow. By adding back these non-operating expenses in addition to the salary that one non-absentee owner pays themselves (one non-absentee owner because this is a reflection of the work that the new owner could replace), you will arrive at what is called SDE (Seller’s Discretionary Earnings). In simple terms, this is the amount of earnings that the seller will have discretion over in the given time period. In determining the value of small and mid-size businesses this number is a critical factor in some of the valuation methods used.
Next, you will determine what it would cost to replace the owner with an employee that has the skills and experience required to fulfill the role the owner currently fills. This could be the role of sales manager, accountant, operations director, office manager, and any combination of these, among others. You can utilize many resources online to find the average salaries for these types of roles in your area. Again, extensive interviewing of the owners and/or key employees is critical to determining the correct number to use here. Once you have this number, you will subtract this amount from the SDE to determine what is called Adjusted EBITDA (EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization). This number is also a critical factor in some of the methods used for valuation of small to mid-size businesses.
There are some other steps that can be taken to even further reflect the earning potential of a business, like using a weighted average of the last 3 to 5 years recase income statements to determine a more normalized reflection of cash flows, but those methods and steps are beyond the scope and objective of this article. It is also important to understand that some of these adjusting entries may also have an impact on your balance sheet and vice versa, like when there is an adjustment for inventory that was not accurate on your returns. This could increase/decrease your cost of goods sold, which in turn will effect your Gross Margin as well as your overall net operating income. It is important to understand the relationship between these statements and how adjustments on one will affect the other.
At the end of the day, the main concept to remember is that recasting financials achieves the goal of determining the business’s true ability to generate cash flow for a new owner. What revenue should be expected to be earned by the new owner, what necessary operating expenses will actually still need to be incurred by the new owner, and what will be left in the earnings for a new owner at the end of the year.