Adjusting Financial Statements: A Complete Guide
If you’re a typical business owner, you’ve structured your company operations to minimize taxes. You might have granted yourself and your family various perks, employed relatives, and written off business-related expenses — all of which contribute to lower earnings and consequently reduce your business’s overall value. These practices, along with others, are aimed at keeping both profits and tax liabilities minimal, sometimes artificially so.
However, when the time arrives to accurately assess your business’s value, it’s essential to “normalize” or make necessary adjustments to your financial statements. This normalization process entails making several modifications to your financial records to unveil your business’s genuine earning potential.
Typical adjustments include:
- Your salary and benefits
- Salaries and perks for family members
- Income or expenses unlikely to persist post-sale
- Personal expenditures, such as personal vehicle, insurance, mobile phone, childcare, medical, and travel costs
- Non-operational income or expenses related to investments or other activities
- Interest payments on business loans
- Exceptional one-time or non-recurring costs
- Non-operational revenue
Eliminating perks, benefits, and expenses that are specific to the owner is crucial for presenting potential buyers with an accurate depiction of your business’s available cash flow.
Fine-tuning your financials empowers you to align your business seamlessly with other enterprises using Seller’s Discretionary Earnings (SDE) or Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA).
SDE stands tall as the prevailing yardstick embraced by astute buyers, seasoned business brokers, and a myriad of adept professionals to assess the value of companies boasting an annual revenue of under $5 million. Meanwhile, the towering EBITDA metric takes the lead in evaluating businesses that command an annual revenue exceeding $5 million.
The art of refining your financial statements stands as a pivotal cornerstone when orchestrating your business for a transformative sale.
Prospective buyers orchestrate a harmonious dance of comparison, employing either the SDE or EBITDA lens. This harmonious analysis enables them to perceive a business’s value rooted in its authentic profit, transcending the confines of mere taxable income. The end result? A meticulously accurate juxtaposition that unveils the true essence of each enterprise.
So, sleeves up, and let’s plunge into the depths of this transformative process…
Definitions of Adjusting Financial Statements
- Discretionary expenses encompass costs covered by the business that provide a personal advantage to the owner. For eligibility, these expenses must exclusively benefit the owner, excluding any perks for the business or its workforce. These outlays should be met by the business and clearly outlined as expenditures within the P&L statements.
- Extraordinary expenses signify those exceptional disbursements handled by the business, unlikely to repeat, and diligently documented as such. Illustrations comprise costs tied to natural calamities, business relocations, or legal proceedings. What doesn’t fall within this scope are endeavors like a misfired marketing campaign or fees for recruiting a replacement manager.
- Non-operating revenue and expenses extend beyond typical business operations, encompassing unique revenue streams or costs. This may encompass interest gleaned from investments, income from divesting equipment no longer in use, or settlements from insurance claims. These non-operating facets should similarly be expunged.
- Non-recurring revenue and expenses encapsulate the atypical or one-off elements that lack anticipation of recurrence. Consider significant legal fees, relocation costs, or expenditures stemming from a natural catastrophe. On the flip side, instances of non-recurring revenue embrace income derived from substantial asset sales or insurance settlements.
List of Sample Adjustments
Adjustments that generally are allowable and can be adjusted.
Streamlining Adjustments: Unveiling Clarity in Specific Categories.
- Accounting: Any fees incurred unrelated to the business or involving other entities or personal matters.
- Amortization: The entirety of amortization expenses.
- Barter Fees: Charges linked to barter arrangements, including associated income.
- Child Care: Payments for child care not connected to business operations.
- Continuing Education: Expenses for further education without relevance to business functions.
- Cost of Goods: Costs for items acquired personally, not utilized for the business.
- Depreciation: The complete array of depreciation charges.
- Entertainment: All personal entertainment costs and related expenditures.
- Insurance: Expenses pertaining to personal needs, like health, auto, dental, and life insurance.
- Interest: All interest costs, unless industry-specific necessity exists (e.g., floor financing for auto dealerships).
- Legal: Personal legal fees in entirety.
- Meals: Any personal meal expenses.
- Medical: All personal medical expenses.
- Memberships: Fees for personal memberships not aligned with business matters.
- One-Time Expenses: Investments in new equipment, start-up outlays, build-outs, significant repairs, and isolated legal fees.
- Owner’s Salary: Your W-2 or 1099 income, inclusive of payroll taxes paid by the company — excluding draws or distributions. This addition applies to SDE calculation, while EBITDA normalization reflects market rates.
- Payroll (Other): Payroll taxes related to your salary and those of non-working family members.
- Personal Vehicle Use: Costs of automotive expenses, payments, fuel, insurance, and repairs for non-business purposes.
- Rent: Adjustment for owned property, normalizing rent to market rates.
- Repairs: Expenses for personal property or home repairs.
- Salary: Salaries directed at non-working family members.
- Supplies: Personal supplies, groceries, and similar items.
- Taxes: Both personal and corporate income taxes.
- Telephone: Costs tied to personal cell phone usage.
- Travel: Expenditures concerning personal or nonessential travel engagements.
Adjustments that are Generally Not Allowed or Cannot Be Adjusted.
- Rent: In the case of property ownership, recalibrate the rent to reflect prevailing market rates. The focus here is the rental cost, not ownership expenses.
- Unpaid Family Members: Remunerations for active family members should mirror prevailing market standards. Conversely, compensations for non-active family members warrant reinstatement.
- Employees: Address disparities by aligning undercompensated employee salaries—especially for family members— with prevailing market benchmarks.
Here is a List of Adjustments That Might be Adjustable:
- Bad Debt: Striking a balance, excessive bad debt can find equilibrium through normalization. Remember, moderation prevails; complete removal might not align with your business’s past and future.
- Charitable Contributions: Owners often weave charitable threads into business, anticipating returns. For instance, a restaurant owner sponsoring a local team reaps visibility. Yet, contributions sans business tie-ins find a different space, like private donations to your church.
- Continuing Education: Not all educational ventures warrant removal; discretion prevails. Delete personal and unrelated expenses, while sparing the ones that uphold business relevance.
- Dues and Subscriptions: Personal costs should steer clear of the business stage. When benefits don’t extend to your enterprise, it’s time to part ways.
- Retirement: Nurturing retirement funds for you and kin stays intact. No detours here; steer away from employee-focused plan upkeep.
- Travel: Traverse the fine line between essential business travel and personal expeditions. Separating the strands ensures clarity without veering off course.
The following expenses should not be removed and cannot be adjusted:
- Advertising: The allure of cost-cutting often leads owners to consider slashing advertising expenses due to perceived lack of returns. Yet, a sagacious perspective acknowledges that triumphant advertising hinges on calculated risks. The price of doing business encompasses these risks, and failure isn’t reason enough for removal. Future proprietors will inherit the mantle of advertising, knowing that even unsuccessful campaigns are par for the course.
- Cash Income: Veiled cash income demands corroborative substantiation through alternate channels.
- Entertainment and Meals: Fostering relationships often finds its canvas on restaurant tables. Dismissing these expenses solely for their optional nature neglects their strategic value.
- Membership: Membership dues, especially those tied to optional clubs like country clubs, warrant scrutiny.
- Rent: Rent’s course remains steady, untouched, if your lease sails above market norms—unless renegotiation prospects beckon.
- Salary: Salaries, an intricate tapestry of compensation, shouldn’t be woven into a web of overpayment. The approach here is discernment, identifying areas open to prudent trimming.
Tips for Making Adjustments
Keep in mind, brevity and substantiation are the pillars of impactful adjustments. The tapestry of your business expenses finds strength in meticulous and accurate documentation.
A single overzealous or inaccurate adjustment can cast doubt over the entirety of your narrative in a buyer’s eyes. This emphasizes the wisdom of engaging an impartial third party like Morgan & Westfield. Their expertise in navigating these waters ensures precise adjustments and an accurate assessment of your SDE or EBITDA.
The depth of your insights and the robust documentation you present to substantiate your expense claims form the bedrock for a swift and lucrative sale of your business.
In the realm of selling your business, a prudent approach to financial adjustments reigns supreme. Numerous reasons underscore the significance of this strategy.
Opting for a conservative stance leads the buyer to perceive a wider landscape of prudence in your dealings. Their due diligence process may be streamlined, reflecting a trust in your overall presentation. Conversely, an aggressive approach can invite closer scrutiny and thorough examination.
Value stands as a dance with risk. Lower risk elevates value.
A buyer engaging a conservative seller envisions a transaction imbued with lesser risk. This perception can lead to a willingness to offer a slightly higher valuation multiple compared to an engagement with an aggressive seller.
It’s crucial to note that in the context of business sale, “aggressive” pertains to the nature of representations being made.
For instance, an aggressive representation could declare, “We’ll undoubtedly achieve 20% annual revenue growth for the next five years.”
In contrast, a conservative representation might state, “We’ve consistently realized revenue growth between 18 to 22% over the past three years, and we aspire to maintain this trajectory. Nonetheless, we remain cognizant of the ever-changing economic and competitive environment, and our estimates remain just that—estimates.”
Should your approach lean excessively towards leniency, buyers may introduce “representations and warranties” clauses in the purchase agreement to safeguard their interests post-closure.
Such clauses might encompass your warranting that your claims align with your best knowledge. Should these representations later prove inaccurate, they can linger, potentially leading to repercussions even after the deal is sealed. Litigation or offsetting losses against future payments might become a reality.
A streamlined approach to adjustments leads to the pristine appearance of your financials as you prepare to hand over the reins. A holistic view of your P&L speaks volumes, with particular attention to the total volume of adjustments made. Fewer adjustments signify a more favorable stance.
Upon their initial glance at your P&L, the total number of adjustments becomes one of several considerations influencing a buyer’s assessment of your business as a potential acquisition. A clean P&L, with minimal adjustments, hints at an efficient and cost-effective due diligence process, enhancing the allure of your business.
In your pursuit of refining financials, consider omitting adjustments under $500. The aim isn’t solely reducing the sum but streamlining the count of individual adjustments. While sub-$500 changes hold minimal sway on cash flow, they create a cleaner landscape within your Profit and Loss statement. This “clean” appearance resonates with potential buyers, projecting a smoother due diligence journey and potentially justifying a higher valuation.
By minimizing adjustments, you position yourself as a business owner who’s a breeze to work with—someone who conducts business transparently and aboveboard. These actions culminate in a foundation of trust, reducing risk and culminating in maximal value as you traverse the path of business sale. There’s even the possibility of lightening the due diligence load.
The zenith of the journey involves striving for zero adjustments, ideally two to three years ahead of a sale. This strategic move amplifies your business’s value and elevates the odds of securing financing for the buyer. This could potentially transform a scenario of post-sale notes into a cash-out triumph at closing.
For those yearning to maximize the purchase price, a cunning maneuver awaits. Assume a conservative stance on adjustments, yet boldly embrace an aggressive valuation multiple. This move necessitates a fortified position, substantiated by robust reasoning, to warrant the higher multiple choice.
|A Comparison of the Effects of Adjustments on Valuation: Comparing A Conservative vs. an Aggressive Approach
|EBITDA (Net Income + Adjustments)
|Asking Price (EBITDA x Multiple)
The path to securing that higher multiple (Business B) often rests on showcasing your business as a beacon of reduced risk. A two-pronged approach beckons: not only must your business exude low-risk characteristics, but your interactions should mirror a disposition of restraint and modesty. Yet, like a skilled dance, avoid overstepping into excess. Infuse your demeanor with conservative optimism, for humility, when overwrought, can become a double-edged sword.
The strategies outlined above offer a tactical advantage—holding potential adjustments in reserve, ready to unveil if the situation warrants. Keep these adjustments in your pocket, their presence known but unspoken, until necessity beckons their emergence.
Should the due diligence phase unearth challenges, seize the opportunity for candid dialogue. Sit down with the buyer, recalibrate, and traverse through the expenses you consciously refrained from adjusting. Articulate your rationale for this restraint, emphasizing your pursuit of conservative accuracy. This display of transparency can wield significant influence, potentially redefining terms and shaping outcomes.
Indeed, the amalgamation of conservatism and humility wields its own rewards, underscoring the wisdom of this strategic path.
How to Easily Produce a Detailed List of Adjustments
Crafting a comprehensive list of adjustments finds its stride through a seamless process. Begin by exporting your comprehensive P&L (or “General Ledger”) from your accounting software into a versatile platform like Microsoft Excel. QuickBooks users can harness the power of a “P&L Detail.” This export magnifies each transaction within your P&L statement, unveiling a comprehensive view.
Once this data resides in Excel’s realm, a simple yet effective approach beckons: a mere “X” or a swath of highlighting across pertinent rows. The beauty of this method lies in its meticulous organization, yielding a detailed, well-structured report poised for scrutiny during the due diligence phase.
Present this report to potential buyers and watch as clarity unfurls before their eyes. The art of tying adjustments to specific entries within your accounting software becomes a seamless symphony. While the report weaves a story of transparency, it’s wise to anticipate requests for source documents. Should the need arise, stand ready to produce intricate invoices or receipts—a testament to your preparedness and dedication to airtight record-keeping.
Your report should look something like this:
When Should I Provide a YTD Normalized P&L to Buyers?
Our strategic counsel suggests furnishing prospective buyers with gross sales data pertinent to the present year. The wisdom lies in maintaining a pragmatic approach, reserving year-to-date financial adjustments for earnest negotiations with committed buyers. By adhering to this approach, you bypass the need for recurrent updates to your financial statements throughout the current year.
Equipping buyers with gross sales figures for the ongoing year typically proves sufficient. Elevate your presentation by also offering a year-to-year comparison, an invaluable perspective. Let’s illustrate: Assuming it’s September, proffer the buyer with gross sales data for January through August of both the preceding and ongoing years.
This thoughtful gesture empowers the buyer to discern your business’s trajectory relative to previous years, enabling the formulation of an informed projection for the current year. This approach hinges on the assumption of a stable expense structure, aligning past and present for insightful evaluation.