Recasting Financial Statements: A Crucial Step In Preparing Your Business For Sale
What does it mean when we say that we need to “Recast” your financial statements as one of the initial steps in preparing to sell your business?
Financial statements and tax returns for most privately-held businesses are prepared for tax purposes, not for business sale purposes. The objective of business owners and their financial advisors is to use all available accepted accounting methods to minimize taxable net income. This is effective for minimizing taxes, but may paint an incomplete picture for business valuation purposes….and for showing the company’s true profitability to a potential buyer. The goal when presenting financial information to a potential buyer is to maximize net income by clearly outlining the owner benefits, net income, and cash flow of the business.
Since bottom-line earnings is the primary factor that influences business value, a proper presentation of the financials is essential. Prospective buyers must be able to appreciate the full benefit of owning the business and be able to understand its actual income-generating ability. By recasting, or adjusting, the financial statements, the actual financial performance of the business can be demonstrated.
A “recast financial statement” is a crucial tool used by a buyer to determine the price they are willing to pay for your business and how much money a bank will be willing to lend to the buyer. This recast statement is a reconstructed representation of the earnings that a buyer would be able to enjoy from the business by:
Normalizing the figures by removing unusual, non-recurring, and one-time or extraordinary income and expenses
Showing adjustments for accounting anomalies
Identifying owner compensation, owner “perks” or fringe benefits
Detailing non-cash expenses, such as depreciation & amortization, interest, investments in future growth, such as new facilities or expansion, and other items that are common in privately-held businesses
THE FOLLOWING IS A CHECKLIST OF SOME OF THE MOST COMMON RECASTING ADJUSTMENTS FOR SMALL BUSINESSES.
The amount of salary or bonus that an owner takes is completely discretionary. Some owners take little or no salary, while others may take more extravagant annual sums. In recasting financial statements, the salary of one owner is added back. If there are other owners receiving compensation and would need to be replaced under new ownership, those salaries would be replaced with “normalized” compensation. Normalized compensation is best defined as what would have to paid to someone to replace the owner’s operational role in the business. Compensation for family members not actively working in the business but being paid through the business should also be added back. It is important to differentiate between salary for working in the business and salary just for owning the business.
Owner “Perks” or Fringe Benefits
In addition to cash compensation, most business owners receive numerous “perks” or benefits that are not required for the daily operation of the business. For example, while a vehicle may be required, a high performance sports car or luxury automobile is not normally necessary. There may also be discretionary expenses reimbursed to the owner that may not be applicable to a new owner and do not affect the profit performance of the company. These include items such as the following:
personal insurance expenses
company contributions to retirement accounts
travel and entertainment expenses that are not essential to the business
personal-use assets: such as a Hawaii condo or a classic Jaguar convertible
legal and accounting expenses paid by the business for the owners, such as estate planning services or drawing up a new will
personal dues and expenses, such as a country club membership or repairs to your personal vehicle
income or expenses that may be transacted between more than one company that the owner owns.
Non-Cash Expenses — Depreciation & Amortization
Interest — A business is typically transferred free and clear of debt and interest-bearing liabilities. Accordingly, interest expense is added back since it will not be incurred by a new owner.
Non-Recurring Income or Expenses
Adding back one-time, extraordinary, or non-operating income or expenses is meant to remove items that appear in the financial statements but are either unlikely to be repeated in the future or are unrelated to the company’s business operations and will not be incurred by a new owner. Common examples include things such as the following:
unusual legal expenses
moving expenses incurred during a company relocation
equipment lease payments since all remaining balances would be paid off at closing
receipt of a one-time contract payment from a new client
payment of a lump sum bonus to an employee
expenditures made for a new facility or expanded operations, such as a new CNC Milling Machine or Metal Lathe that were expensed in full by the business
a gain on the sale of an asset
receipt of insurance proceeds (from a hurricane, for example)
one-time cost of a major write-down in inventory to remove obsolete parts
rent paid to the owner over and above the amount to paid by the buyer (if the business owner also owns the property at which the business operates)
charitable donations and advertising/sponsorship expenses that would not benefit the business
If you are an owner of a business trying to establish value, nothing short of going through the income statement line by line will do. You will want to clarify those expenses that would not likely occur in the future for a new owner of your business. The goal is to make the financial statements of your business clear to a buyer, their accountant and their bank. But be prepared to justify all add-backs with supporting documentation such as invoices and payroll records. Buyers and their accountants will demand a due diligence period to verify all the numbers. Keep in mind, that if adjustments are overly excessive and too many expenses are being tallied as add-backs, banks will probably be averse to provide financing to the buyer to acquire the business.