When valuing a business, it is important to identify and understand the economic value of the business. The economic value of a small business will typically be substantially different from the book value and from the tax mitigated value.
A financial recast is a process where the analyst starts with the tax reported income and expenses of the business and by working with the business owner and/or bookkeeper or accountant, identifies discretionary expenditures with were for the benefit of the business owner. It is common in small businesses top see many expenses that are legitimate tax-deductible expenses but are not required for the successful operation of the business. For example, many business owners write off automobile expenses even though the business does not own a vehicle. The business may be a retail storefront and may not do any pickup or delivery of merchandise. The auto expenses are really just a benefit to the business owner.
A financial recast is typically done to calculate adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization), or SDE (seller’s discretionary earnings). The difference between these two figures is that the calculation of SDE is really EBITDA plus owner’s compensation. In other words, if the owner of a small S-Corp is receiving a salary of $125,000 annually and adjusted EBITDA is $250,000, then SDE would equal $375,000 (adjusted EBITDA + owner’s salary).
There are standard adjustments made to add back (or reverse out) Amortization, Depreciation, Interest and Income Taxes. Add back to what? – A recast typically starts with the taxable income on the first page of the tax return because any prospective buyer will want to be sure that the revenue and adjusted earnings that are stated ultimately tie-back to the tax returns.
Why are these added back? – Because Amortization and Depreciation are non-cash expenses. They are tax-deductible but may not have required an outlay of cash from the business during that tax year. Interest is added back because businesses are typically valued without debt service to cancel the effects that varying capital structures would have on the valuation. Taxes are added back to cancel the effects of varying tax jurisdictions.
The financial recast is important because the value of a business is often times determined by some multiple of earnings. Therefore, as the earnings are increased by the standard adjustments and the add-backs of discretionary expenses, the net effect on the result of the business valuation is also an increase in value. That being said, however, it is important that you understand to which “earnings” the multiplier is being applied. For example, a 3X multiplier on the SDE and EBITDA stated above results in very different values. 3X SDE ($375,000) = $1,125,000 and 3X EBITDA ($250,000) = $750,000.
If you have any questions on financial recasts or business valuations, please contact LA Business Pros at (818) 781-0082.