Business Valuation: Discretionary Earnings

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Green Shade 2

  Where’d that $100,000 go?

Like all professions, the Business Broker/Business Advisor profession has its own keywords and phrases that, in many case, our clients don’t immediately understand. “Contract work in progress” is one such phrase as is the term “working capital”. Those terms, however, aren’t necessarily pertinent to every business that we value, sell or advise for (though “working capital” is an issue for most.) But one of and arguably the most significant and important expressions in our business is “discretionary earnings” – how much of the revenue that comes in the door do the owners have “discretion” over.

Discretionary earnings are the most basic element in a business’ value. It is the answer to the most elemental question buyers ask; “how much money will this business put in my pocket?” It is from this point that buyers will begin to determine the business’ value. Not what the value is to the seller; what the value is to the buyer. Specifically, it will be the determining factor in the buyers’ calculation as to how much they can pay for the business.

Discretionary earnings are sometimes referred to as “seller discretionary earnings”, or “SDE”, and sometimes as “owner’s discretionary earnings”. More experienced brokers generally dispense with the modifier and refer to discretionary earnings, of simply DE.

What Are Discretionary Earnings and Why Are They So Important?

 Sample Income Statement

As alluded to above, DE represents the earning capacity of a given business. As a general rule, the DE number is NOT the bottom line on the tax return. Nor is it the bottom line of the financial statements (“profit and loss” or “income and expense” statements). But you can calculate DE by analyzing both of those documents in a process referred to as “recasting the earnings”.

By “recasting the earnings” we mean the process of identifying those expense items that are not critical to the operation of the business. One of the simplest examples of this might be a $12.99 subscription to Sports Illustrated by the owner of a sports memorabilia manufacturer. A more meaningful example might be a $20,000 trip to the Super Bowl, ostensibly for “research”. Such expenses are discretionary; made at the discretion of the business’ owners meaning that, unlike the electric bill, rent or payroll, they have a choice – discretion – as to whether they should spend that money. Ferreting out these expenses takes time and the experience to ask the right questions. But there are better, clearer and more common examples of such non-critical expenses. Let’s start with what are sometimes referred to as “non-financial” expenses.

There are a number of entries on a tax return and financial statement that are non-financial from an operational standpoint. An example would be “depreciation”. Businesses depreciate long-term assets for both tax and accounting purposes. The former affects the balance sheet of a business or entity, and the latter affects the net income that they report. This last affect is most pertinent to this discussion.

Cap Ex versus Op Ex

When a business buys a piece of equipment, it is referred to as a “capital expense”, or capex, as opposed to an “operational expenses” (opex) such as the rent or electric bill. The piece of equipment – let’s call it a $100,000 truck – gets depreciated over a period of time as determined by the tax rules in effect at the time. As I write this (Spring 2017) the current depreciation or write-off period for such a purchase is three years. This “expense” will be reflected in the depreciation claimed by the business – $33,333 for each of the next three years and each year’s financials and tax returns will include that amount as an expense. (The balance sheet will show an increase in asset value to reflect the fact that the business now owns a new truck. We’ve got a podcast scheduled to discuss understanding balance sheets. Sign up below so you don’t miss it.)

 Sample Balance Sheet

But when the company bought that truck, it exchanged one  asset – $100,000 – for another – a truck. On the balance sheet, Cash on Hand is reduced by $100,000 but Long Term Assets are increased by the same amount. From an accounting standpoint, there was really no expense. However, even though there was no expense, you will find an “expense” on both the tax returns and financial statements of $33,333 for depreciation. This is an accounting entry for taxes; no cash went out the door. As such, to properly value such a business, this amount would be removed from the expense totals and “added back” to pre-tax profits.

Interest expense is treated similarly. If the business decided to finance the purchase of that truck, rather than paying cash, it would be paying interest on the loan every year until paid. Because the decision to finance the purchase was the choice of the owners – a decision made at their discretion – the interest expense is also removed from the expense total and added back to the pre-tax profits. (Depreciation and interest make up two of the six letters in the acronym EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization.)

The Seinfeld Approach: Kramer’s Accounting

Whether it’s the subscription to Sports Illustrated or a new truck, these are expenses that are “written off”; expensed against the business’ revenue. The subscription is an operational expense and is written off when purchased. The truck is a capital expense and is written off over time. The former will generally appear in the Dues and Subscriptions line of the financial statements and tax returns. The latter will appear in the depreciation line as well as on the balance sheet. (For a comical expression of writing something off, check this 52 second video out.)

I’ll be blogging more about tax returns and financial statements and how various entries on both impact the process of determining a business’ value so don’t forget to subscribe so that you don’t miss a post. In the meantime, if you’re a business owner that wants to know what your business is worth, we can provide a valuation for you. If you’d like to learn how to value businesses, we have a course for that – and an earlier post about it, as well. Let me know in the Comments box, below.

Joe

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