When you start planning to sell your business, the term recasting can cause a lot of confusion. You may be thinking “why exactly would I change my financials before sending them to a buyer?”
When you go fishing, you can recast your line. When you go to sell, you can recast your financials.
Same hook, same line, but you might end up in a better spot that attracts more fish.
At MidStreet, we help business owners form an accurate idea of what their business is worth by recasting their financials to find their seller’s discretionary earnings (SDE).
To help you understand how recasting your financials works, we will go over what recasting is, how recasting can be used, the steps involved, and examples of recasting your financials.
Let’s jump in.
What is Recasting?
When you recast your financials, you are changing the way your financials look to get a different view of your business. You will do the following to your financials when you recast:
- Remove things that only happened one time or won’t happen again
- Adjust rent and other expenses to market rates (if they are not)
- Remove owner’s salaries or adjust them to market (depending on the business and the reason for the recast)
In previous blogs, we have talked about calculating for SDE or Seller’s Discretionary Earnings. When you do this, you are recasting your financials to show the profit for one owner-operator in the business.
To calculate for SDE, you will add expenses back that are discretionary or non-recurring that won’t apply to the new owner. For instance, an add back may be a charitable contribution or the cost for a one-time technology upgrade.
Times When Recasting Your Financials Can be Used
The primary reason you will want to recast your financials is planning to sell your business. Recasting your financials will help you show buyers the true profit you’re making from your company.
In all cases, the goal of recasting your financials is to get a “normalized” look at the business’s performance. Having too many personal or non-recurring expenses can make your business appear less profitable than it truly is.
Steps Involved in Recasting Your Financials
To recast your financials, you will go through the following three steps:
Step 1: Start with your tax return (preferably) or income statement (if you can’t use your tax return).
Step 2: Create three columns - one column for your original profit and loss statement (P&L), one for your add-backs, and one for the new recast numbers.
Step 3: Add back the various items you need to find your SDE.
Below we will provide examples of recasting your financials and what will and will not be added back. When done properly, this can help you determine your SDE.
Examples of Recasting Your Financials
To illustrate how you may recast your financials, we will use an example of XYZ HVAC Company.
- XYZ HVAC Company is getting a business valuation performed.
- There is one owner-operator within the business, who has a yearly salary of $120,000 (A).
- This year, the owner had to spend $10,000 to replace tools that were damaged in a fire (D).
- The business is paying for a family phone plan with unlimited data for family members who do not work within the company (F).
- The owner's daughter, sons, and wife use the company credit card to refuel their vehicles each week (G).
Above you can see that certain items are added back or adjusted, such as:
- Owner’s Salary
- Owner’s Payroll Taxes On Salary
- Owner’s 401k and Health Insurance
- Owner’s Discretionary Spending
These items are added back or adjusted to clear up your financials and show your business’s true profit.
Owner’s Salary - Your salary (owner’s salary) is added back because the new owner may not give themselves the same salary that you have given yourself over the years. Their new salary may be higher or lower, which is why keeping your current salary would skew the numbers.
This is also part of the financial benefit you receive - whether you pay yourself more or less should not affect your cash flow.
Owner’s Payroll Taxes On Salary - When removing your salary, we also remove your payroll taxes as the owner. Removing these allows the buyer to see the cash flow before paying themselves a salary.
Owner’s 401k and Health Insurance - Your and your family's health insurance and 401k plan, as the owner, should be added back to find your SDE. These expenses are part of the business profit, so we add them back to understand what the total profit is.
Owner’s Discretionary Spending - These items may be things like your phone, personal car, or other non-business items.
Depreciation - Depreciation allows you to reduce the value of your assets on your taxes over time. Each company decides how they will depreciate their assets on their taxes. The new owner will have a different list of assets and depreciation schedule they follow.
Amortization - You can use amortization as a method to lower the book value of your loan or intangible assets. As the owner of a business, you will have an amortization schedule for your intangible assets. The new owner will have a different amortization schedule.
Interest - You most likely currently pay some amount of interest on loans each year. This interest should be added back because the buyer will have their own interest amount.
Rent Adjustment to Market Rate - If you own your business’s real estate, your financials may reflect a rent rate of $0, when that will not be the case for the new owner. The new owner will either need to rent the space from you, buy the space themselves, or rent from your landlord. The best way to show this cost is by adjusting the rent to the market rate.
The resulting SDE, or cash flow, is the amount of money your business generates per year in profit for 1 owner that also operates the business. It’s an important metric because it helps buyers understand what cash is available to pay their loan and their bills.
Recast Your Financials to Show Your Company’s True Earnings
By showing your company’s true earnings without personal expenses and non-recurring items included, you can paint a more accurate picture of your company’s value. Recasting allows buyers to see how much they could earn as a new owner-operator.
Learn more about finding the value for your business by reading our blog “SDE vs EBITDA: What's the Difference?”
Understanding how to find the value of your business can be difficult. We help business owners find the value of their business every day and can help you determine the value of yours too. Call us today to get your free business valuation.