Adjusted Financials

The following articles are long but important. We highly recommend you read these so you can fully understand the process of normalizing your financials and calculating the seller’s discretionary earnings (SDE) or EBITDA:

Instructions for Adjusting Your Financials

Scrutinize your profit and loss (P&L) statements carefully for the previous three years — review them line by line for each year, and make a list of all adjustments you believe should be made, along with the amount and description for each adjustment. Please be as detailed as possible. We will discuss the adjustments thoroughly during our phone call with you.

This is how your notes should look:

20xx

  • Automotive: $24,200 for a personal vehicle
  • Depreciation: $51,700
  • Dues & Subscriptions: Optional $4,800 for country club membership
  • Entertainment: $1,850 for concert
  • Fuel: $7,200 for fuel for personal vehicle
  • Interest: $37,250
  • Insurance: $24,320 for personal health insurance
  • Legal: $21,430 for personal legal fees
  • Phone: $2,780 for personal cell phone

20xx

  • Automotive: $13,700 for a personal vehicle.
  • Depreciation: $42,450
  • Interest: $36,250
  • Insurance: $26,320 for personal health and life insurance
  • Phone: $2,720 for personal cell phone

20xx

  • Automotive: $14,200 for a personal vehicle
  • Depreciation: $31,700 for non-cash expenses
  • Interest: $37,250 because the new owner would not assume debt
  • Insurance: $24,320 for personal health insurance
  • Legal: $21,430 for personal legal fees
  • Phone: $2,780 for personal cell phone

How to Note Your Adjustments

Every adjustment should correspond to a specific line item on your P&L statements.

Please refer to the specific line item or account name (e.g., automotive expense) and the year on the financial statements when noting the adjustment.

For example, if you have three separate accounts for auto expenses (e.g., fuel, insurance, and maintenance), break up your adjustments into these three separate accounts. Please do not lump them all into one item called “automotive.”

Adjustments cannot exceed the actual amount for an expense.

For example, an adjustment cannot be $10,000 if the expense is only $5,000. We can only deduct what appears on your P&L — we cannot deduct more.

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 the other adjustments.

The expenses being removed must appear on the P&L statements to be adjusted.

A common error is to make an adjustment for an item that only appears on the balance sheet, such as an owner’s distribution or draw. The expenses being removed must appear on the P&L statements in order to be adjusted. This is because if the item did not appear on the P&L (at all/in the first place), it does not need to be adjusted because it isn’t there. Each adjustment must be tied to a specific line item on your financial statements.

Bad Example — I paid $1,000 for country club dues. This was a personal expense.

Good Example — Dues & Memberships – $850 for country club dues for 2012.

Do not include adjustments of less than $500.

Our goal is to reduce the total number of individual adjustments, not the total amount of adjustments. Adjustments less than $500 do not have enough impact on the valuation to include. P&L statements with fewer adjustments look “cleaner” to a buyer and may justify a higher valuation because the buyer may perceive that fewer adjustments must be verified during the due diligence period.

How to Produce a Detailed List of Adjustments

The best way to prepare a list of your adjustments is to export a detailed P&L (or “General Ledger”) from your accounting software to Microsoft Excel or another similar program. This is called a “P&L Detail” in QuickBooks and a “General Ledger” in many other accounting software programs. This report lists every transaction for each account on your P&L statement.

Once you have exported this to Excel, simply mark each adjustment with an “X” or highlight the entire row. The advantage of doing this is that you will have a highly organized, detailed report of all your adjustments available for buyers when they perform due diligence.

Simply show the buyers this report, and the buyer will be able to tie the adjustments to the specific entries in your accounting software.

FAQs

  • No, because we are adjusting just your P&L statements, the only adjustments that should be made are amounts that actually appear on your P&L statements. A draw does not appear on these; it appears only on your balance sheet.

  • Most buyers will ask to see bank statements and federal income tax returns in addition to your financial statements. The bank statements and tax returns should match your financial statements. Some buyers also hire an accounting firm to perform financial due diligence. The accountant will reconcile your financials with the bank statements and possibly your business’s invoices or receipts.

    We recommend organizing your business’s financial backup data by month for the previous three years. Assemble your bank statements, invoices, receipts, etc., for every month, either in a hard folder or in an organized folder on your computer. Document all add-backs or adjustments to the financial statements and organize the source documents by month. For example, if you added back $1,500 from the telephone line expense on the P&L statement, then you should organize documents to back up these claims.

  • SDE includes the owner’s salary, while EBITDA deducts a reasonable amount for a full-time manager. SDE is most commonly used when an individual is buying your business, while EBITDA is most commonly used when a company is buying your business.

    For example, if the net profit from the business is $500,000 per year and the owner takes a $150,000 annual salary, SDE would be $650,000 ($500,000 + $150,000), while EBITDA would be $500,000.

    Why? Individuals who are looking to buy businesses will usually operate the business themselves and will not need to pay a manager to run the business. Companies typically employ a full-time manager to replace the current owner and must deduct this expense from the available cash flow.

  • We need to be able to tie your adjustment to the specific expense line item that the adjustment belongs to in the P&L statement. It’s common for clients to send us an adjustment amount that exceeds the amount of the expense, which it should not.

    For example, some clients send us an adjustment titled “Auto” for $20,000 when the actual auto expense on their P&L statement is only $10,000. Your adjustment cannot exceed the amount of the actual expense.

    It’s also common for groups of expenses to be split up into multiple line items on a P&L statement.

    For example, your automotive expenses might be split into auto expenses, fuel, insurance, maintenance, and interest. If so, please itemize and break down the adjustments based on the actual line item where that specific expense occurs in your P&L.

    This helps ensure your adjustments are accurate and helps facilitate a smoother due diligence process when the buyer verifies the adjustments by reconciling your listed adjustments with your source documents (receipts, invoices, etc.).