Recast Financial Statements Murphy Business Financial Vincent Murphy ans

Recast Financial Statements

Definition

Financial statements of the business that are adjusted to reflect the actual financial benefits of business ownership.

What It Means

Most small businesses are managed to minimize taxable income. Thus, it is often necessary to make adjustments to the reported financial statements in order to express the actual cash flow benefits available for the owner. Adjusting the business financial statements facilitates its comparison to the industry standard ratios.

Here are some Balance Sheet items that may require adjustment:

• Accounts receivable. Review an accounts receivable aging report and remove uncollectible accounts, taking them as a bad debt expense.
• Inventory that is not good and sellable. Inventory that has become damaged or obsolete should be adjusted out.
• Prepaid expenses should be adjusted out if they do not remain with the buyer after the business purchase.
• Cash and cash equivalents are typically retained by the seller. Adjust the balance sheet to have the amount of cash required for running the business.
• Remove any amounts due from shareholders as assets or due shareholders as liabilities.
• Book value of assets. If you plan on an asset purchase, you may wish to adjust or “step up” these to their fair market value. This will give you tax advantages due to a higher basis for asset depreciation.
• Real estate owned by the business needs to be removed if it is not part of the business purchase.
• Carefully review such intangible assets as business goodwill to determine if they should be adjusted.
• Accounts payable. Determine if some liabilities have been accumulated without being paid. If so, they must be added to the balance sheet.

Some items on the Profit and Loss Statement that may require adjustment are:

• Adjust cost of goods to historic averages. It is possible that the business has been using lower cost inventory that may not continue in the future.
• Adjust owner’s salary to a market rate.
• Review and adjust salaries of family members to market rates, if they work in the business.
• Review and adjust depreciation expense consistent with the expected useful life of the underlying assets.
• Adjust the business rent to a fair market rate. If the business owns its real estate premises, include a fair market rent as a business expense.
• Adjust expenses that are incurred at owner’s discretion. Examples are some travel and entertainment, vehicles, memberships, bonus payouts and others.
• Factor out any one-time expenses that are unlikely to occur in the future.

In the professional business appraisal literature the process of recasting the financials is often referred as reconstruction or normalization.

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One of the first steps in the process of valuing your business is to recast or normalize, your most recent profit and loss statements. At the heart of this process is a subject that is familiar here at You’re the Boss — it’s another example of the importance of cash flow.

Small-business owners are accustomed to thinking about revenue and expenses in terms of minimizing taxable income. While that may be a good strategy for tax time, it is not necessarily a fair representation of the financial performance of your company. If you try to place a value on your business without recasting profit and loss statements, you may understate the cash flow from operations, which could, in turn, result in an asking price for your business that is too low.

As I mention in my guide to selling small businesses, most valuations are based on a multiple of earnings. For a smaller, owner-operated business, the most common earnings metric used to value the business is called seller discretionary earnings, or S.D.E. You may also see it referred to as owner’s benefit, cash flow to the owner, seller discretionary cash flow or simply cash flow. Whatever the term, the goal is to provide potential buyers with an accurate picture of all of the available cash flow from your operations.

At the bottom of this post is an example of a fictional profit-and-loss statement (for a fictional company) that has been recast to find S.D.E. The add-backs are the expenses that you want the buyer to know about — any expense that is considered discretionary, extraordinary, nonrecurring or noncash.

When combing through expense accounts looking for add-backs, keep some questions in mind: Were these expenses necessary for the operation of the business? Will a new owner incur these same amounts? Here are some examples of typical add-backs for each category:

Discretionary: One of the primary discretionary expenses of the business is how much the owner pays himself or herself in salary. Others are what might be called perks: personal use of a car or mobile phone, a life insurance policy or even sponsoring your child’s Little League team.

I recently met a florist who traveled to Amsterdam for an international floral design workshop every year. Not surprisingly, the associated travel expenses were significant. Was this a legitimate business expense? Sure. Would it be necessary for a new owner to attend the same workshop in order to continue operating the business successfully? I doubt it. Another discretionary add-back I encountered not long ago was a $40,000 aviation expense. The owner of the business had a private pilot’s license and liked to use his personal aircraft to travel to industry trade shows and expos a dozen times a year. While some travel expenses would be associated with attending these shows, aviation expense hardly seemed necessary for operation of the business.

Extraordinary: In the example below of Ozark Metal Fabrication, the salary paid to a family member may be extraordinary. It’s not unusual for business owners to pay excessive (i.e. well above market rate) salaries to both family members and longtime employees. A larger than usual lawyer bill might also be considered extraordinary. The amounts for these expenses should be adjusted to fair market or normal levels.

Nonrecurring: These are one-time expenses, like moving expenses, or cleanup and repairs from storm damage. It’s reasonable to assume that these expenses would not be incurred by a new owner.

Noncash: The most common noncash expense is depreciation.

It’s important to look at the S.D.E. of your business from a buyer’s point of view. This is the amount of money that a new owner will have leftover after operating expenses to pay himself or herself a salary, service any debt incurred to buy your business, and build or reinvest in the business.

Remember that your profit and loss statement is an example of internal reporting — not to be confused with either financial or tax reporting, which are intended for different end-users. Buyers will ask for both internal financial statements like the P.&L. and balance sheet, as well as corresponding tax returns.

Last, be prepared to defend any add-backs that you include in your S.D.E. analysis: a savvy buyer will expect you to be able to justify each add-back and explain it in detail. Not surprisingly, discussions about add-backs and S.D.E. with a buyer can become contentious.

One listing we had last summer attracted a veteran buyer who questioned every add-back associated with the business. We never did agree on whether a theft at the establishment — an upscale sports bar and grill — counted as an add-back. A general manager had spent the better part of six months stealing almost $50,000 in cash and inventory (liquor) from the first-time owner. I argued that it was unfair to count this as a strike against the profitability of the business, especially under more seasoned ownership. The buyer said it was unfortunate but chalked it up to poor management and eliminated it from S.D.E. What do you think?

Here’s the fictional P.&L. (the shaded entries are the add-backs):

Ozark Metal Fabrication 2009 Income Statement

Coming soon: Multiples and Rules of Thumb.

Barbara Taylor is co-owner of a business brokerage, Synergy Business Services, in Bentonville, Ark. Here is her guide to selling a business.