2 minute read
Why profits matter in business valuations
Whatever the person ‘in the pub’ might say, the majority of business valuations start from what the underlying EBITDA (earnings before interest, tax, depreciation and amortisation) is. Buyers then apply a multiple that reflects growth, risk, strategy and a number of other factors that we will discuss another time. So, it’s important to understand what you can add back to your profits, or need to deduct, to come to the starting point.
You may have come across the terms “adjusted” or “underlying” in respect of a company’s EBITDA. A sceptical business buyer may see them as an inflation of a vendor’s profi ts but these adjustments to profit are important. To ensure you are maximising your selling valuation, they need to be identified early on and then justified during due diligence.
It is very common for there to be adjustments to EBITDA and, just as importantly, the profit that a UK SME may be generating in their annual accounts may not be refl ective of the profit that the same business would generate under new ownership.
WHAT ARE THE MOST COMMON ADJUSTMENTS TO EBITDA?
Shareholder costs
• Salaries – Owner managers commonly remunerate themselves through a mixture of PAYE and dividend income. If the PAYE salary alone does not refl ect the shareholder’s employment contribution to the business, an adjustment will be required. This could be up or down.
• Benefits – Other shareholder costs incurred need to be identified. The most common examples include company pension payments, private healthcare and vehicles.
• Replacement cost – If a replacement is required for outgoing management, a new expense will be included which reduces EBITDA.
• Property – The property occupied by an SME may be owned by the business itself or a related party. Rent and property costs may need to be adjusted to reflect a market rate which will be incurred under new ownership.
• Related parties – Identify transactions involving related parties. Some will be excluded entirely like management charges while others may need to be adjusted if they are not on an arm’s length basis.
Excluded Assets
• Income – Assets that are excluded from a sale may generate income which will need to be removed, the most common example being a property rented to a third party.
• Costs – Similarly, there may be expenditure linked to these excluded assets which has not been capitalised, this can be added back.
• Revaluations – Movements in the value of these assets will impact the profit and loss account. This could be in the form of revaluations or foreign exchange gains and losses in the case of financial assets.
Exceptional and non-recurring items
• Professional fees – Costs incurred that may suppress profits in a given year. This could cover sale transaction costs, legal costs relating to a litigation dispute or accountancy tax restructuring advice.
• Investment – Expenditure included within the P&L incurred for future benefit. Includes items such as non-capitalised R&D and recruitment costs. This would also include capital expenditure which has not been capitalised on the balance sheet.
Accounting policies
• Provisions – These should be checked for year-on-year consistency and accuracy. Common examples are stock value and customer bad debt
• Disposals – Disposals of capital assets trigger profit and losses in the company accounts, these are driven by accounting estimates and often are unrelated to the trade of the business.
• Missing accruals – Check that costs are allocated correctly. Commonly, SMEs pay and recognise bonuses in arrears. This can be substantial year on year where bonuses fluctuate.
• Owned assets – Owning assets can mask the cost for a business when reviewed in EBITDA terms. Be aware of recurring capital expenditure regularly replacing assets.
WHY DOES IT MATTER?
Identifying the adjustments within your business can help you plan for exit and understand how your business valuation could be determined. Unlike the valuation which is usually proposed by the buyer, owner adjustments are proposed by the vendor so should be clear, identifi able and justifiable. Missing out items can be detrimental to value and, like many aspects of transactions, they are negotiable!
By Daniel Morgan, Managing Partner, Haines Watts Esher