The goal: To adjust the company’s profits upward so you can apply the price-earning’s and operating profit (EBIT) multiples to the higher profits for the highest value and selling price. Even if you're not in the market to value or sell the business today, the concepts and examples illustrated in this advisory are crucial in understanding how you will set a value and selling price in the future. They work in reverse also, to help you determine the best purchase price for a business you’re interested in buying.
Adjusting the income statement is especially critical for closely held businesses because the owners typically keep reported profits as low as possible to minimize taxes. Some of the techniques used to lower taxable income and profits include increasing salaries, declaring bonuses, setting aside more retirement money, and writing off inventory.
Based on our investment banking experience over the last 30 years, a company’s adjusted profits, on average, will be about 80% above its reported profits. So don't penalize yourself today or limit the value of the business just because you made salary, tax, and cash flow decisions which lowered the profits in the past. In most cases, the impact of those decisions can be explained and illustrated to a potential buyer by showing them the adjustments you made to reflect the company's true profitability.
Income Statement Adjustments
Adjustments to a company’s earnings should add back to earnings: (a) excess compensation paid to the company's owners/officers and family members above reasonable amounts, (b) extraordinary tax writeoffs of bad debts, unusable inventory and equipment, etc., (c) unreasonably high fringe benefits, (d) special year-end bonuses, (e) investments in affiliated businesses, and (f) any nonrecurring expenses incurred in one year which benefit the company over future years, e.g., preparing and printing sales brochures, new product development costs, establishing a new sales office, etc.
Example of add-backs: If the company's reported pretax income is $100,000 ($65,000 after taxes) and these adjustments total $60,000, its adjusted pretax income is $160,000. To this figure, apply a tax rate (say, 35% overall) to obtain the company's adjusted net income of $104,000 (65% times $160,000). Thus, the company's reported aftertax income was adjusted from $65,000 to $104,000. Now, to determine the value of the business, let's apply a simple 10 price-earning's multiple (p/e) to both numbers:
Reported Net Income: $65,000 times 10 p/e equals $650,000
Adjusted Net Income: $104,000 times 10 p/e equals $1,040,000
Added Company Value equals $390,000
The added value of $390,000 represents a 60% increase above the value based on the company's unadjusted income statement. That shows you the importance of adjusting the financial statements before starting the valuation process and/or setting a price tag for selling the business. Note: If the company is a sole proprietorship, partnership, S corporation, or limited liability company, you must adjust the income statements as if it were a regular (C) corporation with applicable corporate, not personal, tax rates.
Reference Manual: How to Value Any Business with 16 Case Studies and 27 Valuation Methods