How to Recast a Financial Statement when Selling a business!
RecastingFinancial Statements When Selling A Business
Whatdoes it mean when we say that we need to "Recast" your financialstatements as one of the initial steps in preparing to sell your business?
Financial statements and tax returns for most privately-held businesses areprepared for tax purposes, not for business sale purposes. The objective ofbusiness owners and their financial advisors is to use all available acceptedaccounting methods to minimize taxable net income. This is effective forminimizing taxes, but may paint an incomplete picture for business valuationpurposes. The goal when presenting financial information to a potential buyeris 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 businessvalue, maximizing the presentation of the financials is essential. Prospectivebuyers must be able to appreciate the full benefit of owning the business andbe able to understand its actual income-generating ability. By recasting oradjusting the financial statements, the "real" financial performanceof the business can be demonstrated.
A "recast financial statement" is a reconstructed representation ofthe earnings that a buyer would be able to enjoy from the business. It removesnot only one-time or extraordinary income and expenses, but also adjusts foraccounting anomalies, identifies owner compensation, owner "perks"orfringe benefits, non-cash expenses such as depreciation and amortization,interest, investments in future growth such as new facilities or expansion, andother items that are common in privately-held businesses.
The following are some of the most common recasting adjustments:
Owner Salaries
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 extravagantannual sums. In recasting financial statements, the salary of one owner isadded back. If there are other owners receiving compensation and would need tobe replaced under new ownership, those salaries would be replaced with“normalized” compensation. Normalized compensation is best defined as whatwould have to paid to someone to replace the owner's operational role in thebusiness. Compensation for family members not actively working in the businessbut being paid through the business should also be added back. It is importantto differentiate between salary for working in the business and salary just forowning 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 ofthe business. For example, while a vehicle may be required, a high performancesports car or luxury automobile is not normally necessary. There may also bediscretionary expenses reimbursed to the owner that may not be applicable to anew owner and do not affect the profit performance of the company. These includeitems such as the following:
- insurance expenses
- travel and entertainment expenses
- family employees
- a large life insurance contract or pension plan
- personal-use assets such as a Hawaii condo or a sailboat
- income or expenses that may be transacted between more than one company that is owned by the same seller
Insome instances, nothing short of going through the income statement line byline to gain an understanding of what lies behind the numbers will do.
Non-Cash Expenses
The most common non-cash expense is depreciation and is added back to netincome.
Interest
A business is typically transferred free and clear of debt and interest-bearingliabilities. Accordingly, interest expense is added back since it will not beincurred by a new owner.
Non-Recurring Income or Expenses
Adding back one-time, extraordinary, or non-operating income or expenses ismeant to remove items that appear in the financial statements but are eitherunlikely to be repeated in the future or are unrelated to the company’sbusiness operations and will not be incurred by a new owner. Common examplesinclude things such as the following:
- unusual legal expenses
- moving expenses incurred during a company relocation
- expenses related to expiring equipment leases
- 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
- a gain on the sale of an asset
- receipt of insurance proceeds (from a hurricane, for example).
Ifyou are a seller of a business trying to establish value, you will want as manydollars as possible added-back to your financial statement to improve businessprofitability and thus its value. Buyers will question all add-backs.Therefore, adjustments should be provable. If you cannot prove it, the buyerwill not want to give you credit for it. Sellers want to maximize value andbuyers want to minimize it. This tug-of-war is usually part of the negotiationprocess in buying and selling a business.