If you’ve decided that you want to sell your business, we first need to look at the numbers to determine the most likely selling price for your business. Otherwise known as “normalization,” a financial recast is the very first step in the business valuation process. Once you have sent the last 3 years of your tax returns or profit and loss statements to your business broker, they will be able to start on the path of determining your business’s true “owner benefit” or “discretionary earnings.”
What Exactly Is A Financial Recast?
We all know that small businesses are notorious for running as many personal expenses through their business as they can get away with. That’s a big unofficial benefit of being a small business owner. Most of us do it, and I’d say that a good 95% of the businesses we sell do it too. The goal is to limit the amount of profit that we show on our tax returns, for obvious reasons.
Some business owners who want to sell are hesitant to give us copies of their tax returns, because they are not showing a lot of profit on the bottom line, and they are afraid it’s going to hurt their business’s value. We need to assure them that what they are showing as profit is, in most cases, a non-issue, because we will be doing a financial recast, which will most likely add more to the bottom line. A recast is the normalization of your business expenses. We will be doing “add-backs,” of certain expenses that are non-cash deductibles, personal expenses, and non-essential business expenses.
How Does A Financial Recast Work?
Your business broker will load all of the data that you provide, via your tax returns and profit and loss statements, into a spreadsheet. All income and expenses will be taken into account. Then there are certain line items that are always added back in, including but not limited to: the owner’s salary, the payroll taxes on that salary, depreciation, amortization, and other expenses that a new owner wouldn’t have, like interest as an example.
Then we would have a meeting with you to discuss each of the line item expenses where we will go through them one by one, to ensure that they are indeed a true necessary expense of the business or find out if there are any personal expenses in there. We would then add back in any personal expenses. The key here is that you would have to be able to prove to a buyer, with documentation, that these are in-fact personal expenses and not business expenses. If you can’t prove it, then we unfortunately can’t add it back in. For example, phone expense: if you pay for your spouse’s and kids’ cell phones through the business, then we can add that expense back in as owner benefit. The new owner won’t be paying for your family’s cell phone expenses, so that is not a business expense. We would add the portion of the phone expense that is the family cell phones back into the bottom line. We would then repeat that process for any other provable personal expenses.
Why Is a Financial Recast Important?
Because the reported profit on business financials aren’t always showing the true picture of what a new owner would be getting, we need to do a financial recast. A normalization of the finances is going to highlight what the actual owner benefit or discretionary earnings will be. A buyer needs to be able to see what the bottom line to them really is, and then they are going to verify that those numbers are correct during due diligence. So, it’s really important to get the recast done correctly in the beginning, so there are no surprises down the line.
Of course, having clean financials with minimal add-backs and showing more profit on your tax returns is a much more straight-forward purchase for a buyer, but that is not always the reality of what we are working with in small business sales. Getting to the true owner benefit that your business generates will directly relate to the value of your business. So, that’s why doing the financial recast is the first step in the valuation process, so we know exactly how much discretionary earnings we are working with. Once we have that number, then we can move on to the next step of analyzing comparable sales and industry multiples, in order to find your most likely selling price.
If you are thinking of selling your business, and want to have one of our business brokers perform a valuation and give you their opinion of value, then please reach out to us…we are happy to help.