Recasting Financial Statements

The right way to present financial information when selling your Company

When selling a business, it is critical to properly present financial information. This will maximize the perceived value and, in turn, the valuation of your Company.

Financial statements and tax returns are prepared for tax purposes, not for business sale purposes. The objective of most business owners and their financial advisors is to use all available accepted accounting methods to minimize a company's taxable net income. This strategy is effective for minimizing taxes, but is entirely inappropriate for business sale purposes. The goal when presenting financial information to a potential acquirer is to maximize the presentation of net income and cash flow.

Since the primary factor influencing a company's value is its earnings, maximizing the presentation of the financials is the key. It is imperative that potential buyers are able to "read between the lines" to appreciate the actual cash flow or income generating capability. By recasting or adjusting the financial statements, potential acquirers will recognize the "real" financial capability of the business.

The term "recast financial statements" refers to financial statements that are adjusted to identify owner compensation, owner "perks" or fringe benefits, one-time/extraordinary expenses, non-cash expenses (i.e. depreciation and amortization), interest, investments in future growth and an array of others. There are approximately 60 potential recasting adjustments that could be applicable when recasting financial statements.

The purpose of recasting is not to mislead acquirers. The goal is to provide a clear understanding about the cash generating potential of the business. The following will discuss some of the most common recasting adjustments:

Principal's Salaries
The amount of salary (or bonus) that an owner takes is completely discretionary. Some owners take little or no salary, while others pay themselves exorbitant annual sums. In recasting financial statements actual compensation is replaced with "normalized" compensation. Normalized compensation is best defined as what you would have to pay someone to replace your operational role in the company. This most commonly ranges between $50,000 and $150,000. It could also be as little as zero if the owner has an absentee or passive role in the company. It is important to differentiate between salary for working and compensation for owning a business and then present the balance as recast profit distribution to the owner.

Owner "Perks" / 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. While a manager may need a vehicle, he or she may not need a high performance sports car or luxury automobile. There may also be substantial discretionary expenses reimbursed to the owner that could be curtailed by new management without affecting the sales or profit performance of the company. These include insurance expenses, travel and entertainment expenses, family employees and other expenses that will not be applicable to an acquirer once the current owner exits the business.

Pension Plans
In many businesses the owner receives a substantial pension that is expensed through the business. This would clearly be non-recurring to a new owner.

Non-Cash Expenses
The most common non-cash expense is depreciation. It enables a company to write off capital expenditures over the course of several years. A CPA will recommend that a client accelerate the depreciation schedule in order to maximize the deduction for tax purposes. Since the useful life of the machinery is typically longer than the depreciation period, adjustments must be made to recast a portion of the depreciation expense when presenting the financials to an acquirer. It is generally inappropriate to recast 100% of depreciation since a portion relates to the actual amount of capital expenditures needed to replace worn equipment or keep up with changes in technology.

A business is typically presented as being transferred free and clear of interest bearing liabilities. Accordingly, interest expense should be added back to recast profit since it will be non-recurring to an acquirer.

Non-Recurring Expenses
Also referred to as one-time or extraordinary expenses, these items are not likely to be applicable to an acquirer going forward. Common examples include unusual legal expenses, moving expenses incurred during a company relocation, expenses related to expiring equipment leases and a multitude of others.

Recasting adjustments apply to both the income statement and balance sheet. The book value of the equipment on the financial statement rarely coincides with market value. The fair market value of equipment in its current condition is generally substantially higher than the book value and must be adjusted on the balance sheet. It is also common to normalize the on hand inventory to reflect the saleable inventory, at cost, that will be included in a transaction. A recast balance sheet will also identify assets and liabilities that are excluded from a transaction. For example, if cash is going to be retained by the seller and not included in the transaction, this will be presented accordingly in the recast balance sheet.

Presentation of the financial information is something that cannot be taken lightly during the business sale process. With proper guidance and expertise, a seller can significantly increase the perceived value of the company and ultimately increase the price and terms received.

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