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.
Interest
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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