Adjusting Financial Statements: A Complete Guide

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

The normalization of your financial statements involves making numerous adjustments to calculate SDE or EBITDA.

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

Common adjustments to financial statements:

  • All owner’s salaries and perks 
  • Family members’ salaries and perks
  • Expenses or income that aren’t expected to recur or continue after the sale
  • Personal expenses not related to the business, such as personal auto, insurance, cell phone, child care, medical, and travel expenses
  • Depreciation
  • Amortization
  • Interest payments on any business loans
  • Investment or other non-operating expenses or income
  • Other one-time or non-recurring expenses
  • Non-operating revenue

Tips for Making Adjustments

  • Be Thorough: All adjustments should be concise, verifiable, thorough, and accurate. The more detail you provide to the buyer, and the more you back up your reasoning for adjustments with documentation, the more likely your business will sell quickly and for the best possible price.
  • Be Conservative: When selling a business, always be conservative when making adjustments to your financials. The fewer adjustments, the cleaner your financials will look. Eliminate any adjustments less than 0.5% to 1.0% of your SDE or EBITDA, and ideally, all adjustments before selling your business.

How To Produce a Detailed List of Adjustments

  • The best way to prepare a list of your adjustments is to export a “General Ledger” (called a Profit and Loss Detail report in QuickBooks) from your accounting software to a spreadsheet, such as Microsoft Excel or a similar program. Once you’ve exported this to a spreadsheet, simply mark each adjustment with an “X” or highlight the entire row.

Introduction

Like most business owners, you probably operate in a way that keeps your taxes low.

You may have given yourself and your family members perks and benefits, kept offspring on the payroll, and written off other expenses through your business – all of which contribute to decreased earnings and lower taxes. 

All well and good. But when the time comes to properly value your business, your financial statements must be “normalized” or “adjusted” to form the basis of an accurate evaluation. 

This involves numerous calculations to arrive at the true earning capacity of your business and is one of the most important steps in preparing your business for sale. 

How Your Financials Are Adjusted in M&A

Making adjustments to your financial statements involves removing owner-specific perks, benefits, and expenses. This process is necessary to show potential buyers your business’s available cash flow.

Adjusting the financials allows you to compare your business with other businesses using 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 other professionals for valuing companies with annual revenue of less than $5 million.
  • EBITDA is the most common metric used for valuing businesses with more than $5 million in annual revenue.

Buyers compare potential acquisitions using SDE or EBITDA. By comparing the SDE or EBITDA of one company with another, buyers can easily understand a business’s value based on its actual profit rather than its taxable income. This provides a more accurate comparison between target companies.

Definitions of Adjustments

The following are descriptions of the different types of adjustments:

Definitions of Adjustments
Discretionary expensesPaid for by your business but personally benefit only you, and not your business or employees. Such expenses must be documented as an expense on your P&L statements.
Extraordinary expensesExpenses that the business paid for that are exceptional, unlikely to recur, and documented as extraordinary. Examples include expenses associated with natural disasters, relocation of your business, or a lawsuit. Expenses like failed marketing campaigns or headhunter fees to replace a resigned manager don’t qualify as extraordinary.
Non-operating revenue and expensesExtraordinary expenses or revenue unrelated to your business operations, such as interest earned on investments, revenue from the sale of superfluous equipment, or insurance settlements.
Non-recurring revenue and expensesUnusual or one-time in nature and not expected to recur, such as a significant legal expense, moving costs, a cleanup bill from a natural disaster, or revenue from the sale of a large asset or an insurance settlement.

List of Sample Adjustments

Allowable

Following is a list of adjustments that generally are allowable and can be adjusted:

  • Amortization: All amortization.
  • Barter Fees: Any barter-related fees and income.
  • Child Care: Payments for child care.
  • Continuing Education: Any education expenses not related to your business operations.
  • Cost of Goods: Expenses for any personal purchases not used for your business.
  • Depreciation: All depreciation.
  • Entertainment: All personal entertainment and related expenses.
  • Insurance: Any personal insurance expenses, such as health, auto, dental, and life insurance.
  • Interest: All 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 don’t relate to your business and aren’t used for business networking.
  • One-Time Expenses: Any investments in new capital equipment, such as one-time start-up expenses, build-outs, one-time major repairs, or one-time legal fees.
  • Owner’s Salary: Your W-2 or 1099 income, including your payroll taxes and any payroll taxes paid by your company – but not your draws or distributions, unless they appear on your P&L statements (they shouldn’t, but we do see this). Only salary in the form of W-2 or 1099 income should be added back. Note: This means added back when calculating SDE, or normalized to market rates when calculating EBITDA.
  • Payroll (Other): Any payroll taxes for your salary and that of family members who don’t work in the business.
  • Personal Vehicle Use: Any personal automotive expenses, payments, fuel, insurance, and repairs for non-business purposes.
  • Rent: If you own the property, adjustments to normalize the rent to market rates. 
  • Repairs: Any repairs for your home or other personal property.
  • Salary: Salaries paid to family members who don’t work in the business.
  • Supplies: Personal supplies, groceries, toilet paper from Costco, etc.
  • Taxes: All personal and corporate income taxes.
  • Telephone: Personal cell phone-related expenses.
  • Travel: All expenses related to personal or nonessential travel.

Any adjustments you make should be concise, verifiable, thorough, and accurate. The more detail you provide to the buyer, the more likely your business will sell quickly.

Not Allowable

The following are expenses that can be reduced or limited but should not be removed and can’t be adjusted:

  • Advertising: Owners often attempt to remove fees related to advertising because they feel the campaign didn’t bring in any business and was unsuccessful. But advertising always involves risk, and its success is hard to judge, so the cost can’t be removed just because the campaign was unsuccessful. If you want to sell your business soon, stick to low-risk campaigns.
  • Cash Income: While it used to be common and easier to get paid for unreported cash income in a business, it’s nearly impossible unless you own a small, cash-based business, such as a chain of car washes or laundromats. If you want to sell your business soon, begin reporting all income.
  • Entertainment & Meals: Dining with clients is a critical way of building relationships. The expenses shouldn’t be removed just because they were optional. If you want to sell your business in the near future, eliminate any discretionary entertainment or meal expenses.
  • Membership: Membership fees in country clubs and other optional groups should be identified and adjusted, although any savvy buyer will diligence the benefits to the business of such memberships. In some cases, these fees can be adjusted.
  • Rent: If you’re paying what’s considered an over-the-market rate for your lease, rent shouldn’t be adjusted unless your lease could be renegotiated.
  • Salary: Overpaid employees’ salaries shouldn’t be removed. This can, however, be identified as an expense that could be reduced post-closing. If you want to get paid for this value-add, then you must implement the change well before the closing, which eliminates the risk of implementation for the buyer.

Maybe Allowable

Following is a list of adjustments that might be allowable and therefore adjusted:

  • Bad Debt: Any bad debt (accounts receivable) from your customers that’s considered excessive, based on your previous years. We can often normalize this, but you shouldn’t remove it completely. If your business had bad debt in the past, it likely will again. This should be normalized based on prior years by deducting an even amount each year (reserve for bad debt) or by spreading a large bad debt expense over several years.
  • Charitable Contributions: Owners often make charitable contributions with the expectation of getting business in return. An owner of a business might sponsor a local sports team, and that might influence local customers, but the results of this exposure are difficult to measure. You can adjust any personal contributions that aren’t related to your business or that didn’t lead to exposure, such as a private donation to your church, but you should leave in any that did.
  • Continuing Education: Some educational expenses are considered discretionary but shouldn’t be removed just because they were optional. These expenses should be removed only if they are personal in nature and unrelated to your business.
  • Dues and Subscriptions: Any personal memberships that may have benefited the business, such as country club dues, should not be removed.
  • Retirement: Your 401(k) and IRA contributions for yourself and any family members should be adjusted. Don’t remove fees related to maintaining retirement plans that benefit your employees.
  • Travel: Any expenses related to personal or nonessential travel can be adjusted. Any nonessential or excessive business travel should be identified. However, some travel is necessary for most businesses.

Expenses such as charitable donations, further education, and memberships may be adjusted if they mainly benefit the owner and not the business. 

List of Adjustments
AllowableNot AllowableMaybe Allowable
AmortizationAdvertisingBad Debt
Barter FeesCash IncomeCharitable Contributions
Child CareEntertainment & MealsContinuing Education
Continuing EducationMembershipDues and Subscriptions
Cost of GoodsRentRetirement
DepreciationSalaryTravel
Entertainment
Insurance
Interest
Legal
Meals
Medical
Memberships
One-Time Expenses
Owner’s Salary
Payroll (Other)
Personal Vehicle Use
Rent
Repairs
Salary
Supplies
Taxes
Telephone
Travel

Normalized Expenses

Following is a list of expenses that should be normalized to market rates:

  • Rent: If you own the property your business is housed in, the rent should be adjusted to current market rental rates. In other words, your business should pay your real estate entity a current market rate to rent the property, or what you’d charge the buyer to rent it after the closing. This amount should be based on a competitive market, not the cost of ownership.
  • Unpaid Family Members: Salaries for working family members should be adjusted based on their replacement cost in the market. Salaries for any family members not working in your business should be added back.
  • Employees: Salaries for underpaid employees, such as family members working in the business, should be adjusted to market value.

Tips for Making Adjustments

Be Thorough

All adjustments should be concise and verifiable. The more thorough and accurate your documentation is regarding your adjustment, the better.

If you’re aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything you say from that point on. This is why I recommend you hire an objective third party like Morgan & Westfield to make these adjustments and calculate your SDE or EBITDA.

The more detail you provide to the buyer, and the more documentation you have to back up your reasoning for claiming your adjustments, the more likely your business will sell quickly and for the best possible price.

Be Conservative

Always be conservative when making adjustments to your financials for M&A. There are several reasons why this is important.

If you’re conservative here, the buyer will assume you’ve been conservative elsewhere and may seek to verify fewer of your representations during due diligence. On the other hand, if your adjustments are aggressive, the buyer may feel the need to perform more thorough and exacting due diligence.

Value is a function of risk. The lower the risk, the higher the value. A buyer who’s dealing with a conservative seller will view the transaction as less risky and may be willing to pay a slightly higher multiple than they would an aggressive seller.

Keep in mind that “aggressive” versus “conservative” in the context of selling a business refers to the representations being made.

  • An example of an aggressive representation: “We can definitely grow revenue by 20% per year for the next five years.”
  • An example of a conservative representation: “We have grown revenue by 18% to 22% during the previous three consecutive years, and we hope this trend will continue. We are aware that the economic and competitive landscape can change quickly, and our estimates are just that – estimates.”

If your behavior is excessively liberal, the buyer may include “representations and warranties” in the purchase agreement to protect themselves after the closing.

This could include language in which you warrant that any claims you made were true to the best of your knowledge. If your representations later prove to be untrue, they’ll come back to bite you even after the closing. The buyer can sue you or offset losses from your representations against future payments via setoff.

The fewer the adjustments when selling your business, the cleaner your financials will look. Step back and look at your profit and loss (P&L) statement. How many total adjustments do you have? Don’t look at the total in dollars (for example, $936,950 in adjustments) but rather at the total volume (e.g., 14 adjustments in the most recent year). The fewer the adjustments, the better.

If you act cautiously in your adjustments, buyers will see you as low risk, may perform lighter due diligence, and will likely pay a higher multiple for your business. 

When a buyer first looks at your P&L, the total number of adjustments is one of many factors they’ll consider when evaluating your business as a potential acquisition. If your P&L is clean, with minimal adjustments, then they’ll likely assume that due diligence will be faster and less expensive.

I recommend eliminating any adjustments less than 0.5% to 1.0% of your SDE or EBITDA. For example, if your EBITDA is $1 million, don’t make any adjustments unless they exceed $5,000 to $10,000. Smaller adjustments make your “adjusted P&L” look busier and don’t impact the valuation enough to justify them. 

Here’s the impact of a $10,000 adjustment on the value of a business with $1 million in EBITDA at a 4.0 multiple:

Business ABusiness B
EBITDA$1,000,000$1,000,000
Additional Adjustment$0$10,000 (1% of EBITDA)
Multiple4.04.0
Value of Business$4,000,000$4,040,000
$40,000 (or 1% of the purchase price)

While $40,000 is nothing to sneeze at, the additional adjustment comes at a cost – it muddies up your P&L, and the buyer may perceive more risk as a result and end up paying a lower multiple.

Instead of more adjustments, I suggest fewer, then asking for a slightly higher multiple to account for the fact that your P&L is now “cleaner.” In the case above, you’d only have to receive a 4.04 multiple, which is 1% higher than the multiple for Business B. The purchase price will likely end up being the same, but the path to get there may be smoother.

Impact of Adjustments on Multiples

Note that the size of the adjustments is a percentage of SDE or EBITDA, and the impact on the multiple will be exactly the same, regardless of the multiple. So, removing an adjustment that is 0.5% of your EBITDA will impact the valuation by 0.5%. The reverse is true for the multiple. You would only need to receive a 0.5% higher multiple to offset the adjustment you didn’t make. Instead of a 5.0 multiple, you would need to receive a 5.025 multiple. 

Your goal should be to reduce the total number of individual adjustments, not total adjustments. Adjustments less than 0.5% to 1.0% of your SDE or EBITDA don’t impact cash flow enough to impact your valuation. A cleaner P&L statement may justify a higher multiple, and therefore valuation, because of a simpler due diligence process. 

Eliminate any adjustments less than 0.5% to 1.0% of your SDE or EBITDA. If your EBITDA is $1 million, make no adjustments unless they exceed $5,000 to $10,000. 

If you minimize adjustments, a buyer may assume you’ll be easier to deal with than other owners and are running your business in an upright fashion. Collectively, these strategies build trust with the buyer, reducing risk and maximizing value for you during the sale.

The ideal scenario is to eliminate adjustments altogether at least two to three years before a sale. This will increase the value, improve the buyer’s odds of obtaining financing for your business, and maximize the multiple you receive. Buyers love to see a clean P&L with few to no adjustments.

If you want to maximize the purchase price, there is a simple strategy: be conservative regarding your adjustments but be aggressive regarding the multiple you choose when valuing your business. You must develop a strong position to justify a higher multiple.

Here’s an example:

Effects of Adjustments on Valuation: A Conservative vs. an Aggressive Approach
Business ABusiness B
Net Income$ 1,000,000$ 1,000,000
Adjustments$ 500,000$ 300,000
EBITDA (Net Income + Adjustments)$ 1,500,000$ 1,300,000
Multiple3.03.5
Asking Price (EBITDA x Multiple)$ 4,500,000$ 4,550,000

You can often justify this higher multiple (Business B) if you can demonstrate to the buyer that your business represents less risk than other businesses. Not only must your business be perceived as less risky, but you as well. Your disposition in all interactions must be modest and conservatively optimistic. But don’t overdo it: humility can backfire if it’s overdone.

The strategies above don’t prevent you from keeping “potential adjustments” in your back pocket, ready to whip out as needed. You can mention them later in the sales process, but only informally and if necessary.

If possible, eliminate all adjustments two to three years before a sale. This will increase the value of your business and improve the buyer’s chances of obtaining financing. 

If the buyer uncovers problems during due diligence and attempts to renegotiate the purchase price, sit down and walk them through the expenses you decided not to adjust. Tell the buyer you wanted to be as conservative as possible and point out each expense you believe should be adjusted but which you chose not to.

How To Easily Produce a List of Adjustments

The best way to prepare a list of your adjustments is to follow these steps:

  1. Export a “General Ledger” (called a Profit and Loss Detail report in QuickBooks) from your accounting software to a spreadsheet, such as Microsoft Excel or a similar program. This lists every transaction for each account on your P&L statement.
  2. Mark each adjustment with an “X” or highlight the entire row. The advantage of doing this is that you’ll have a highly organized, detailed report available for buyers when they perform due diligence.
  3. Show the buyers this report, and they’ll be able to tie the adjustments to the specific entries in your accounting software. They may request the source documents, such as receipts for the transactions, so be prepared to produce detailed invoices or receipts.

Your report should look something like this:

Conclusion

Trading efficiently in the eyes of the taxman and in the eyes of your potential acquirer can be two entirely different things. 

Closing that gap fairly and demonstrably is a key phase in properly valuing your business and preparing it for sale. But the process of normalization isn’t simple – you must pay careful attention to the lists above to determine which benefits can be adjusted and which can’t. 

In life, as in business: proceed with cautious optimism and act early. Neutralize potential discrepancies before they arise, and you’ll be another step closer to the right sale price for your business.