Sunday, June 26, 2016

Don’t fall for this income double-counting trap when analyzing a small business

In the past month I’ve had two business-buying clients who’ve gotten caught in this trap. 

If you buy a business believing that the cash flow to the owner is $200K and in reality it’s only $100K, you’ll be in big trouble.

How does this happen? Watch the video here:

In order to understand what is going on in a small business, a process of normalizing the income statement is necessary.

We need to understand the true benefit of ownership.  Sometimes, personal benefits are hidden in the expense lines.  For example: a restaurateur who takes personal groceries home from the business.  These items can add up substantially.

In the normal process of doing this, the analyst takes the net income and then starts ‘adding-back’ items to get a new normalized cash flow.  This cash flow figure is called the Seller’s Discretionary Earnings or SDE.  It is the total cash available to an owner of the business.

Small businesses are typically valued as a multiple of SDE.

Here’s the problem: sometimes owners don’t take a salary which would appear in the wages expense, they instead take dividends which happens on the balance sheet.

Net income from an income statement appears in the equity section of the balance sheet.  At the end of the year, it gets rolled into ‘retained earnings.’

So if a seller is taking dividends, it is removed from the equity section of the balance sheet.  If you add the dividends to net income, you are effectively double-counting the same dollars.

Don’t let it happen to you. 

Learn how to buy a business the right way and control risk.  Visit to learn more.  If you want to engage my help, send me a message or call me at 506 381 8416.  I work with people all around the world.

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Thanks and I’ll see you next time. 

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