The Most Important Number Your Accountant Never Told You About

At one time or another, every small business owner wants to know what their business is worth…even if they aren’t the least bit interested in selling.  Many will ask their accountant for advice.  The trouble is that while accountants are usually good at accounting, they are usually not so good at valuing small businesses…especially when the business owner is also a client.  In the accounting world, people are typically trying to minimize taxable income in order to pay less tax, while in the small business appraisal world, taxes are not a consideration in estimating value.

Naturally, business owners try to avoid paying more taxes than they have to.  This is called tax avoidance, which is legal, and not to be confused with tax evasion, which is illegal.  For the small business owner, this can mean having a company car, health insurance, and other perks, paid in pre-tax dollars by the business, rather than after-tax dollars by the owner.  Of course, some owners are more creative or aggressive in how they minimize their taxable income.  In addition, owners’ salaries can vary wildly, even among similarly sized businesses within the same industry.  Consequently, the “bottom line” (pre-tax profit or earnings before tax) from an accounting standpoint, can be very misleading.

 

EXHIBIT A

	Red Widget Co.	Blue Widget Co.
Revenue	1,000,000	1,000,000
Cost of Goods	380,000	410,000
Gross Profit	620,000	590,000
Operating Expenses	560,000	480,000
Earnings Before Tax (EBT)	60,000	110,000

 

Looking at Exhibit A, one might be tempted to conclude that  Blue Widget Co. is the more profitable, and therefore, the more valuable company.  Fortunately, most business owners and their accountants would correctly want to “add back” the owner’s salary, as this is typically at the discretion of the owner(s) themselves.

 

EXHIBIT B

	Red Widget Co.	Blue Widget Co.
Revenue	1,000,000	1,000,000
Cost of Goods	_380,000	410,000
Gross Profit	620,000	590,000
Operating Expenses	560,000	480,000
Earnings Before Tax (EBT)	60,000	110,000
Salary Add-Back
Owner Salary	120,000	70,000
EBT + Owner Salary	180,000	180,000

 

Exhibit B demonstrates that, after adding back each owners’ salaries, the picture of profitability changes substantially.  Instead of Blue Widget Co. being $50,000 more profitable than Red Widget Co., they are equally profitable at $180,000 each of EBT plus owner salary.

This is not the end, however.  As most business owners understand, there are other business expenses that benefit the owner(s), but are not necessary to operate the business.  These are often referred to as perquisites (owner perks).  Since owners’ perks vary from company to company, it is important that these perks are added back in order to compare companies on an “apples to apples” basis.

 

EXHIBIT C

	Red Widget Co.	Blue Widget Co.
Revenue	1,000,000	1,000,000
Cost of Goods	380,000	410,000
Gross Profit	620,000	590,000
Operating Expenses	560,000	480,000
Earnings Before Tax (EBT)	60,000	110,000
Salary Add-Back
Owner Salary	120,000	70,000
EBT + Owner Salary	180,000	180,000
Other Add-Backs
Health Insurance	20,000	–
Auto Lease, Fuel & Insurance	15,000	–
Discretionary Earnings	215,000	180,000

 

Exhibit C shows the full calculation of Discretionary Earnings to the owners of each company.  When measured by Discretionary Earnings (DE), Red Widget Co. is more profitable than Blue Widget Co.  Without understanding the Discretionary Earnings of a business, there is no way to properly estimate its value.  This is why Discretionary Earnings is the most important number every business owner should understand.