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The
Concept is to Provide a Picture of the True Earnings of a
Business
To provide a simple example of why P&Ls are adjusted: Two
companies are for sale, the same industry, same sales, Company A
has a net profit of $200,000 while Company B has a net profit of
$100,000.
On the surface you would want to buy Company A and would likely
be willing to pay more for it. On closer inspection (i.e.
making “adjustments”) you discover that Company B’s owner pays
himself $200,000 more than the owner of Company A.
The adjusted P&L would now show Company A earning $200,000 and
Company B earning $300,000. Without adjustments it is not
possible to have a clear picture of the true earnings of a
business.
In addition to the above simplified example (excess owner
compensation), adjustments to the P&L will include expenses that
a buyer will not have after a purchase. Those could include
certain owner perks and one time expenses (to mention a few).
These are generally referred to as “discretionary expenses” or
“addbacks”.
The key for a buyer (and the seller if he wants due diligence to
go smoothly), is that all adjustments should be valid and
verifiable. The buyer will make an offer based upon
the representations of the seller (including adjustments to the
P&L), but in due diligence these must be proven.
EBDITA:
Earnings Before Depreciation Interest,
Taxes and Amortization
Very simply the expenses for depreciation, interest, (income)
taxes and amortization are removed (“adjusted out”) from the
P&L. The company’s bottom line is thus increased and now called
EBDITA. Depreciation and amortization are removed since they are
non-cash expenses (these are just tax deductions based upon a
prior purchase of an asset, i.e. equipment). Interest is
removed because the buyer is not assuming any seller debt.
Taxes are removed because value analysis for privately owned
businesses is determined on a pre-tax basis.
In private companies being positioned for sale, adjustments
(removing discretionary expenses or occasionally adding a
required expense) to the P&L will also be included. An
appropriate owner salary is left in as an expense. This produces
an “adjusted” EBDITA.
Now that an (adjusted) EBDITA has been determined, how is it
used? Most valuation methods use EBDITA as the basis of
determining value. However, if we take one more step and
calculate the “ACF” of the business, the resulting number
becomes important to a buyer.
ACF: Adjusted
Cash Flow (also called “Sellers Discretionary
Cashflow”)
To arrive at ACF just remove from (adjusted) EBDITA whatever
owner compensation is (still) in expenses in the P&L (since
different buyers may need different levels of compensation, this
“zeros out” this expense – to be added back into expenses
later).
As a buyer you now have the basis to determine: if you purchase
a business for “X”, will the business produce sufficient cash
flow to pay yourself (or a manager) a salary, pay the bank debt
used to purchase the business, along with any additional
expenses planned?
Example: Let’s assume the bank payments (principal and
interest) for debt to buy the company at a price of “X” is
$50,000 a year for the term of the loan. Buyer A’s salary
requirement is $60,000 a year and he/she has determined that a
sinking fund of $10,000 a year is needed to replace equipment in
the future.
If the business is generating at least $120,000 a year in ACF,
then this buyer (in theory) can purchase the business, pay
himself, pay the bank, and have the funds to purchase needed
equipment (assuming the business keeps generating the same
results). This would be a valid purchase for Buyer A.
Would this business be a valid (financial) purchase for any
buyer interested in it? Not necessarily. Let’s
assume Buyer B has less downpayment and his bank payment would
be $55,000 per year. Also let’s assume this buyer needs a
salary of $75,000 and his expectation for replacing equipment is
$5,000 per year. Therefore, he needs this business to be
producing at least $135,000 per year in ACF. This would
probably not be a valid purchase for Buyer B if it is only
generating $120,000/yr.
As can be seen, even when a “good” valuation of a business
determines a value (say “X” above), it doesn’t mean it is a
value with which every buyer will agree. Of course, there
are other factors involved in the decision making process for a
buyer (can the business expenses be lowered, sales improved,
does the buyer bring any synergy, new customers, etc.).
If this has only confused you, and you would like to understand
it better – call us at Keate Partners and we will be happy to
step you through the concept (along with explaining “What are
valid addbacks?”).
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