Determining the Real Profit of a Privately Owned Business
Adjusting the P&L and Arriving at EBITDA
The Concept is to Provide a Picture of the True Earnings (cash flow) 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 a year 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 (at the same salary). 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.
EBITDA: Earnings Before Interest, Taxes, Depreciation, 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 EBITDA. 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 (normally). If the owner’s salary is not at a reasonable level (too high or too low), then the owner’s salary is replaced with a reasonable salary and the EBITDA will be adjusted up or down by the difference. Income 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 be shown. An appropriate owner salary is left in as an expense. This produces an “adjusted” EBITDA.
Now that an (adjusted) EBITDA has been determined, how is it used? Most valuation methods use EBITDA as the basis of determining value (along with considering the value of the assets).
Additionally, the buyer now has a basis of expected cash flow to determine if his/her cash flow needs (salary for the new owner or manager, bank payments if the purchase is financed, etc.) are satisfied for the purchase of the business.
NOTE: In the offering memorandum from Keate Partners, the actual P&L of the business is shown, then the adjustments (“addbacks”) are shown below the net profit and added to the net profit to arrive at EBITDA. Thus the buyer sees the actual P&L and can decide if he/she agrees with the adjustments.