Bottom Line: Computing Adjusted Net Income

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Posted on February 22, 2009 by Peter Siegel, MBA

Bottom Line: Computing Adjusted Net Income

It's known by more than a dozen short phrases and acronyms and it is one of--if not THE--key factor buyers look at when evaluating business offerings as likely purchase candidates.

How much money remains after payment of all the expenses needed to conduct business? That's the question on buyers' minds as they review a company's profit and loss statement. And it's usually the same figure to which sellers refer when they promote the value of their enterprises. And though the principals may be thinking of the same magic number, they're approaching it from opposite sides of the transaction, and often confusing one another by using different ways to describe it.

In the interests of promoting better communication among those involved in the purchase and sale of small and mid-market companies, it might be useful to clarify the idea that business people mean to convey when they talk about the amount of money still in the cash drawer or company bank account, after the revenues are collected and the bills are paid.

TWO WAYS TO MEASURE

Much of the mix-up has to do with the fact that there are two basic ways to measure earnings generated by a company. The first approach follows the straight-forward calculation used to arrive at the amount remaining after subtracting out the cost of goods sold, salaries, employer contributions, and selling expenses, then deducting all necessary overhead items such as rent, utilities, insurance, maintenance, marketing, bank and credit card costs, and fees paid for professional and other outside services, and the miscellaneous costs required to operate.

It's this first definition of profit that buyers want to know about and that sellers want to emphasize as the "true profit." That's because it's invariably higher than the one resulting from the second way of defining a company's earnings.

This second approach, usually expressed fully in a company's profit and loss statement, is different from the first calculation because it includes subtractions of allowable deductions so the owner can show a smaller bottom-line sum on which to pay taxes.

Typically, these allowable deductible items include taxes paid, interest on sums borrowed to help fund the company, cash reserves being accumulated to replace capital assets (depreciation), and recovery of investments previously made in the firm with after tax dollars (amortization).

Not only do these allowable deductions represent expenses not absolutely necessary to conduct business, they also reflect highly individualized ways of funding and managing tax liability involved in a business. The seller's "earnings" as calculated to determine tax liability, may be quite different from the figure on the P&L for the same company, once it's owned and operated by the buyer.

DISCRETIONARY EARNINGS

While marketing a company and quoting the earnings figure on the profit and loss statement--and that's the figure on which taxes will be calculated, the seller wants to convey to prospective buyers that if they run business exactly as the seller has, they will have more money to use than the figure listed at the bottom of the current P&L. The seller or seller's broker, explains that any expenses listed, but not needed for the successful performance of the business, should be "added back" to the stated profit, and that the result is the seller's discretionary earnings.

This explanation is intended to help buyers understand that anyone who takes over the business and runs it the same way--assuming revenues and costs are unchanged--will have the same discretionary earnings to allocate for expense items used to reduce tax liability, with the balance treated as income subject to taxation.

It is the effort to communicate this principle that results in the use of various terms intended to define what is meant by earnings. That's when buyers encounter phrases such as seller's discretionary earnings (also expressed as SDE), earnings before interest, taxes, depreciation and amortization (commonly referred to as EBITDA), seller's discretionary cash (SDC), and various other terms, including adjusted net and adjusted annual cash flow.

SOME ALERTS

Buyers should be aware, incidentally, that other so-called expenses might be properly added back to determine the cash actually produced by the business. Included are the owner's personal expenses, health and life insurance premiums, auto expenses not related to the business, and obvious tax "dodges" such as salaries paid to the owner's family members even though their contribution is not worth what they earn.

Buyers also need to know that some "discretionary" allowable deductions do involve a real cost. If the seller carries back part of the purchase price, the interest paid on that loan does not have to be included as income subject to taxation, but it is a real expense. Another example is depreciation. Some income dollars may be declared non-taxable because they are set aside to replace capital assets, although not actually spent in the year the deduction is taken. But at some point most every business owner has the need to replace equipment, and that will entail an actual cost to the business.

The shorthand terms and acronyms used to aid in business sales discussions can help buyers and sellers communicate if both know what they're talking about. And it's usually a good idea for parties to get their accountants involved to make sure these conversations don't contain misunderstandings.