Recasting Financial Statements when selling a business
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. 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, maximizing the 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 "real" financial performance of the business can be demonstrated.
A "recast financial statement" is a reconstructed representation of the earnings that a buyer would be able to enjoy from the business. It removes not only one-time or extraordinary income and expenses, but also adjusts for accounting anomalies, identifies owner compensation, owner "perks" or fringe benefits, non-cash expenses such as depreciation and amortization, interest, investments in future growth such as new facilities or expansion, and other items that are common in privately-held businesses.
The following are some of the most common recasting adjustments:
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: insurance expenses travel and entertainment expenses, family employees, a large life insurance contract or pension plan, personal-use assets such as a Holiday home or a sailboat, income or expenses that may be transacted between more than one company that is owned by the same seller. In some instances, nothing short of going through the income statement line by line to gain an understanding of what lies behind the numbers will do.
The most common non-cash expense is depreciation and is added back to net income.
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, 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/loss on the sale of an asset, receipt of insurance proceeds. If you are a seller of a business trying to establish value, you will want as many dollars as possible added-back to your financial statement to improve business profitability and thus its value. Buyers will question all add-backs. Therefore, adjustments should be provable. If you cannot prove it, the buyer will not want to give you credit for it. Sellers want to maximize value and buyers want to minimize it. This tug-of-war is usually part of the negotiation process in buying and selling a business.