In our experience, most small business owners are unsure of how much their businesses really earn. Most understand, in a general sense, whether or not they are turning a profit, but as to the financial details, they leave that up to their accountant. Sometime in early April, the owner may receive a copy of their prepared business tax return, but that typically only leads to more confusion. Trying to determine the profitability of a business by looking at the bottom line of a tax return doesn’t work. And asking your accountant is usually not a solution either.
Fortunately, there is a way to get a reasonably accurate picture of the profitability of any business, even when the owner has deliberately managed the finances in a way to minimize his or her taxable income. As we have discussed in the past (here), discretionary earnings is a generally recognized standard for determining the real earnings of a business. While it is not perfect, it does do a good job of straightening out the sometimes complex and mysterious finances of a closely-held small business.
Properly calculated, discretionary earnings will “normalize” the financials of a business enterprise, so one can get a true understanding of the earnings of the business. Have a spouse working in the business, but not drawing a paycheck? Discretionary earnings will fix that. Taking more salary in one year, and more owner’s draw in the next? Discretionary earnings will fix that too. Have some “gray area” expenses? No problem…that too is taken care of. Basically, any type of revenue or expense that is “unusual” or “not the way it probably should have be done” will be corrected using discretionary earnings.
Why should one care? Well, nearly every business owner should care about discretionary earnings because this is how nearly every business is valued in the marketplace. And if one wants to sell (or gift) their business someday, it pays to know what it is worth…even if one is selling the business to a family member or employee.
So how is discretionary earnings calculated. Fortunately, we have created a (relatively) simple step-by-step calculator below where you can try it out. It does take some time and effort, but it’s worth it. And be aware that this is not a magic calculator…the law of garbage in, garbage out still applies. So be careful, and sent us a note if you have a question. We are glad to help.