When utilizing a cash flow or earnings based method of business valuation, one of the most important steps to arrive at an accurate estimate and conclusion of business valuation is normalizing the income statement.
This post on business valuation will discuss four of the more common adjustments that a business valuator applies to arrive at normalized cash flow or before-tax earnings:
- Management Salaries
- Salaries paid to related parties
- Rent or lease costs
- Discretionary expenses
Management Salaries
As part of a tax strategy private business owners may draw a salary from their company that is less than market wage. In business valuation, an adjustment must be made to the owner’s salary to a market wage for the services provided by the owner if he or she has an active role in the company.
The best way to think about the adjustment is this: if the owner of the private business in Toronto did not have an active role in the company, what salary would he or she have to pay a third party to manage the operations? This adjustment can affect the cash flow or earnings of the company and ultimately the assessed business valuation.
There are several tools that a business valuator in Toronto can use to determine the accurate market salary of a manager or C-level (CEO, CFO) executive. Several parameters can determine the salary of a manager including the industry of the subject company and the level of revenue generated by the company.
As an example, consider an owner of a private company that has an active role and draws a salary of $40,000 per annum. In this example, the market wage to pay a third party to perform the same role as the owner should be $200,000. Therefore, the adjustment to the cash flow or net earnings of the private company for business valuation purposes would be a deduction of $160,000 ($200,000 – $40,000).
Salaries Paid to Related Parties
Another adjustment made in business valuation is to the salaries paid to related parties. This is a similar concept to the adjustment to the management salary – any wages paid by the company to an individual must reflect the market wage for services performed. Often a private company may pay a wage to family members that do not have an active role in the company for income tax purposes.
For business valuation purposes, the salaries paid to family members that do not have an active role in the company will be added back to arrive at normalized cash flow or earnings.
Rent or Lease Costs
This adjustment for business valuation purposes typically occurs if a related private company owns the property and building where the operating company operates. To normalize cash flow, the business valuator must analyze whether the rent or lease costs paid by the operating company reflect the market commercial lease costs for the area.
The business valuator will examine the costs per square foot of similarly sized properties in the same geographical area. The adjustment may result in an increase or decrease to the cash flow depending on the costs paid by the operating company.
Consider the example:
Company X pays a nominal $10,000 in occupancy costs to related Company Y that owns the building of operations. The building is approximately 3,000 square feet. The business valuator researches the market and finds that similar sized buildings in the area and determines that the market rent should be closer to $7,000. Therefore an adjustment to the annual cash flow of the company should be an add back of $3,000 ($10,000 – $7,000).
Discretionary Expenses
Discretionary expenses can include but are not limited to, the following: personal cell phone/internet/cable costs, personal automobile costs (lease/insurance/fuel), meals and entertainment, and travel expenses.
It is important in business valuation to account for only the expenses of the subject private company in arriving at a conclusion of business value. Depending on the owner of the company discretionary expenses included on the private company’s income statement may be very high or low.
The owner must be aware and keep a good record of personal expenses because the cash flow or before-tax earnings of the company may be artificially deflated based due to high discretionary expenses.
The above adjustments are some but not all of the adjustments that are made in the business valuation process. Other items are considered including one-time or non-recurring expenses. For example, high advertising costs in one year that aren’t normally reflected in the ongoing business operations.
An experienced business valuator will have a detailed conversation with his or her client to determine the types of adjustments that need to be made to the income statement in order to normalize the cash flow. A good valuator will also explain any adjustments in the accompanying business valuation report.