Understanding how much money the business owner is truly making is one of the most difficult, if not THE most difficult aspects of buying a business. If the 5.6 million-word tax code doesn’t make it difficult enough, business owners and their accountants sometimes only add to the confusion with their “creative” bookkeeping techniques.

You’ve probably heard a dozen terms that describe the profits of a business – Cash Flow, True Owner Net, Seller’s Discretionary Earnings (SDE), Seller’s Discretionary Cash Flow, Owner Benefit, EBITDA – these terms all pretty much answer the same question … How much money does the owner really make?

What you have to understand and accept first, before even looking at a financial statement or report, is that the objective of a business owner is to make as much money and pay as little tax as possible, and that “good” accountants and CPAs find ways to help business owners accomplish this goal. This can make your attempt to determine true cash flow a little more difficult but always keep one thing in mind – business owners have to prove what they claim.

Recasting

The first step we take in determining a business’ cash flow is to recast the financials. Recasting financials is a fancy term that simply means we “correct” them or adjust them to provide a more accurate picture of what the business is truly producing in regards to profit. When we recast financials, we are looking for expenses to “add back” into the net profit of the business – we call these items add-backs or fringe benefits.

Personal Expense

As a rule-of-thumb, anything that is a personal expense is an add-back. This commonly includes items such as family cell phone plans, family health insurance coverage, personal vehicles and meals. Keep in mind that some of these items could be a combination of both personal and business expenses, so we must be careful only to add back the portion of the expense that is truly for personal use.

Discretionary Spending

In addition to personal expenses, we also have discretionary spending to account for. These expenses can include charitable donations, excessive legal fees or season tickets to a local sporting venue. What we are looking for here are specific items, although they are often legitimate business expenses, that are not mandatory to operate the business – hence, discretionary, meaning a new owner can choose not to spend this money and the business will not suffer.

Non-Recurring Expense

Another major add-back can be the one-time, non-recurring or extraordinary expense. Maybe a business owner paid cash for a new piece of equipment or maybe there was a major repair that had to be done to the building after a storm. These are examples of legitimate business expenses that were unique and only appear once in several years of financial records. We add those items back in because they skew the “normal” cash flow picture of the business.

Owner’s Salary

Don’t forget about the owner’s salary, or any payouts to partners or other family members that are shown as expenses. We add these items back too. They are the easiest expenses to add back because the owner could very easily choose not to pay himself a salary and those dollars would simply fall to the bottom line profit of the business.

EBITDA

Finally, a note on EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization. This simply refers to a business’ profit before any interest, certain types of taxes, depreciation and amortization are deducted as expenses. Any CPA will tell you that EBITDA is universally accepted. Although EBITDA becomes less and less relevant as businesses become smaller in size, those items are still added back in our recast.

So once we have examined the financial statements and determined what personal expenses, discretionary spending, non-recurring charges, owner’s salary and EBITDA items should be added back, we have completed the recasting of the financials. Now we have a very clear understanding of what the business’ true cash flow is. Think of it as a pot of money at the end of the recasting rainbow – then it’s up to you as the new owner of the business to determine how you want to run your books, and allocate those funds accordingly to empty your pot as you see fit.

Jeremy Furtick is a Senior Business Intermediary with VR Huntington Business Group Inc. a VR Business Sales firm in Dallas (www.vrbigd.com).

VR Huntington Business Group, located in the heart of the DFW Metroplex, serves the entire Dallas-Fort Worth Metro area as well as North Texas. The company specializes in Business Brokerage, Mergers & Acquisitions, Business Valuation and Consulting services focusing on small businesses and mid-market companies.