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

$10,000

Depreciation

$10,000

Amortization

$10,000

Discretionary expenses

$10,000

Adjustments for extraordinary, non-operating, non-recurring expenses

$10,000

Seller's Discretionary Earnings (SDE)

$250,000

 

Discretionary Expenses are expenses the business paid for but are a personal benefit to the owner. To qualify, the expense must personally benefit the owner, not the business or its employees. If these expenses were paid for by the business, they must be documented as an expense on the profit and loss statements. Be conservative in your estimates. If buyers believe you are exaggerating, they will conclude you are untrustworthy and will walk away.

Extraordinary Expenses are those that the business paid for that are exceptional, unlikely to reoccur and are documented as extraordinary. Examples include expenses associated with natural disasters, relocation of the business or a lawsuit. Examples that don’t qualify include a marketing campaign that failed or headhunter fees to replace a manager that left.

Non-Operating Revenue and Expenses are extraordinary expenses unrelated to the business operations, such as interest, revenue from the sale of equipment that is no longer used in the business, insurance settlements, etc. Non-operating income should also be removed.

Non-Recurring Expenses and Revenue are expenses that are unusual or one-time in nature and not expected to recur, such as a high legal bill, moving expenses, a cleanup bill from a natural disaster, etc. Non-recurring income could be from the sale of a large asset or an insurance settlement.
 

Examples of Allowable Adjustments

These adjustments must be listed:

  • Accounting – Any accounting fees unrelated to the business or for other businesses or personal matters

  • Amortization – All amortization

  • Bad Debt – Any bad debt that is considered excessive based on your prior years

  • Barter Fees – Any barter-related fees and income; Itemize any business expenses you paid for by bartering.

  • Charitable Contributions – Personal contributions made

  • Child Care – Payments for child care that do not relate to the business

  • Continuing Education – Any continuing education expenses that are not related to the business

  • Cost of Goods – Any item purchased for personal use

  • Depreciation – All depreciation

  • Dues and Subscriptions – Any personal fees, such as country club dues that have no expectation of benefiting the business

  • Entertainment – Any personal entertainment or related expenses

  • Insurance – Any insurance expenses related to personal needs, such as health insurance, auto insurance, dental insurance and life insurance

  • Interest – Interest expenses, unless necessary in your industry, such as floor financing for auto dealerships

  • Legal – Any personal legal fees

  • Meals – Any personal meal expenses

  • Medical – Any personal medical expenses

  • Memberships – Any fees for personal memberships that do not relate to the business

  • One-Time Expenses – Any investments in new equipment, one-time start-up expenses, build-outs, major repairs or one-time legal fees, among others

  • Payroll Taxes – Any payroll taxes for your salary, as well as the salaries of non-working family members

  • Personal Vehicle Use – Any automotive expenses, payments, fuel, insurance and repairs for non-business purposes

  • Rent – If you own the property and you are not paying yourself market rent, then adjust the rent to the market

  • Repairs – Any repairs for your personal home or other personal property

  • Retirement – Your 401(k) and IRA contributions and those for any family members

  • Salary – Your salary and/or any salaries paid to non-working family members; adjust salaries paid to family members to a comparable salary in the market, if necessary

  • Supplies – Personal supplies, groceries, etc.

  • Taxes – Personal and corporate income tax

  • Telephone – Any personal cell phone-related expenses

  • Travel – Any expenses related to personal or non-essential travel

While making adjustments to your financial statements will make your business look as profitable as possible, some expenses that must be listed may result in a negative adjustment.
 

Examples of negative adjustments

  • Rent – If you own the property, then list the amount you would charge a new owner if you are interested in renting your real estate to a new owner. This may be a negative adjustment if you are paying yourself less than what you would charge a new buyer for rent.

  • Unpaid Family Members – List a reasonable salary for any family members who work in the business and are unpaid.

  • Employees – List the compensation for any underpaid employees, such as family members working in the business. This compensation should be adjusted to market value.
     

Expenses you typically cannot remove or adjust

The following expenses should not be removed; however, we can identify them as expenses that can be reduced or limited. This is an important distinction. When adjusting the financial statements, it is important to be conservative.

  • Advertising – Owners often attempt to remove fees related to advertising because it did not bring in any business and was considered a wasted expense. However, developing successful advertising campaigns always involves risk. This is a business cost and cannot be removed just because the campaign was unsuccessful. A new owner must continue to advertise and market the business, and many campaigns are unsuccessful.

  • Bad Debt – We can normalize this, but you should not remove it completely. If you had bad debt in the past in your business, you are likely to have it again. This should be normalized based on your prior years by deducting an even amount each year or spreading a large bad debt expense over several years.

  • Cash Income – Unreported cash income should be verified through other means.

  • Charitable Contributions – Owners often make charitable contributions with the expectation of getting business in return. For example, an owner of a restaurant might sponsor a local sports team. Doing so generates publicity and exposure for the business; however, directly measuring the results is impossible.

  • Continuing Education, Dues and Subscriptions – Some educational expenses are considered discretionary and should not be removed just because they were optional. These expenses should only be removed if they were personal in nature and were unrelated to the business.

  • Entertainment, Meals – Dining with clients is a critical way of building relationships. These expenses should not be removed just because they were optional.

  • Memberships – Membership fees in country clubs and other clubs that are optional should be identified.

  • Rent – The rent should not be adjusted if you are paying what is considered an over-the-market rate for your lease, unless the lease could be renegotiated.

  • Retirement – Remove your 401(k) and IRA contributions for yourself and any family members only. Do not remove any fees related to maintaining retirement plans that benefit your employees.

  • Revenue – Only a CPA or accountant can and should adjust your revenue.

  • Salary – Overpaid employees’ salaries should not be removed. This can, however, be identified as an expense that could be trimmed.

  • Travel – Remove any expenses related to personal or non-essential travel. Any non-essential or excessive business travel should be identified. However, some travel is necessary for business.

Important – Be conservative when adjusting your financial statements. The adjustments should be concise and verifiable. If you are aggressive or inaccurate with one adjustment, most buyers will question the credibility of all of the other adjustments. Please take time and care with this step. We will advise you along the way as well.