by Joey Young | March 29, 2021
Editor’s Note: This is the first of a four-part series. Access the entire series at the bottom of this article.
Once you have decided that you are interested in purchasing a particular business, you’ll need to decide how much money that business is actually worth and whether any payments you make after financing the purchase price would be affordable given the current profitability of the business.
Helpful steps to determining these things include:
- Find out how profitable the business currently is on paper. (Current Net Profitability)
- Figure out how profitable the business is in reality. (Adjusted Net Profitability)
- Calculate a narrow range of prices you’d be willing to pay based on the predicted future of the business.
- Decide how to protect yourself and the new business before you make an offer.
During the 90s, the most popular way to appraise a business was to calculate the company’s earnings before depreciation, interest, taxation and amortization (EBDITA). Since then, a few other items have been added to and subtracted from that calculation to arrive at a much more accurate estimate of a company’s value. But either way, we have to start by understanding what the company’s value is on paper, and the EBDITA helps us do that.
For our example, we will assume that we are interested in buying an existing health club and that its net income on the most recent tax return is $100,000/year. We will then be signing a commercial property lease where the gym is located. We are not buying the property, just the business. For situations where real estate purchases are included, we might appraise the property separately from the business and then add the two values together for a total price.
- Find the Current Net Profitability
How much profit did the company make in the last tax return period? Finding “Current Net Profitability” is the first step and is usually pretty easy to determine when the seller is willing to show you the company’s tax returns. Tax returns are difficult to falsify, so if a seller is hesitant to show you them or perhaps insists on giving you “in-house” accounting reports only, be wary. Unfortunately, there are many businesses out there for sale because they are not profitable, so be careful and insist on eventually receiving the tax returns to verify the seller’s claims. You’re looking for the “net income” on the tax return.
- Calculating the EBDITA: Take the current net income from the first step and add the following items retrieved from the same tax return:
- Depreciation expense: If you look through the tax return you will likely see an expense called depreciation. Depreciation expense is a non-cash expense and is really just a tax advantage owners take for buying new equipment or building structures. That expense needs to be added to the net income since it didn’t really take money from the business and isn’t always correlated very well with the time period it’s applied to.
Example: If the gym contained $25,000 in depreciation that year, just add it back to the $100,000 net income and the new adjusted profit increases to $125,000.
- Interest: The interest a business paid each year on credit cards or loans won’t be exactly the same as the loans and credit card interest you might pay, so add that amount to the net income as well. It’s typical that debts like those mentioned are paid off by the seller once the sale is complete anyway. Therefore, interest expense would often be zero going forward.
Example: If the seller’s gym paid out $10,000 in interest from loans on that recent tax return, we add that amount to make the new adjusted net profit equal $135,000.
- Corporate income tax: Since most of the businesses you’ll consider buying are LLC’s or S-Corps, it will be uncommon to see a corporate income tax on the tax return. But if there is one, add it to the adjusted net profit. Taxes are generally considered to be difficult to predict accurately (for many years out anyway) and are the responsibility of the current owner. Although they are rare, I included this item because I want to make sure that if some seller ever tries to add payroll taxes, personal taxes, or various licenses or sales taxes payable to the adjusted net profit in order to increase its value, you will realize as a potential buyer that only corporate income tax would ever be added to the adjusted net profit. Never add regularly occurring licenses, fees, taxes, or personal income taxes.
Example: Our Gym is an S-Corp and has no corporate income tax, so the adjusted net profit remains $135,000.
- Amortization: Look through the recent tax return you retrieved, and you might see an expense called amortization. Unfortunately, the word amortization is used for two different items sometime – i.) debt payments or ii.) intangible asset depreciation. In the case of business valuation, it’s referring to the depreciation definition only. Amortization expense is a non-cash expense and is really just a tax advantage the owner takes for buying non-tangible assets, such as the ownership of the Nike swoosh symbol or some depreciation of goodwill the seller purchased earlier. It’s not too important to describe exactly what it is for our purposes, but that expense needs to be added to the adjusted net profitability since it didn’t really take money from the business.
Example: Our gym doesn’t have any amortization expenses, so we will ignore it. The adjusted net profit remains at $135,000.
In the next article, we will look at what items might be needed to adjust an EBDITA calculation further. Those calculations will determine the actual cash flow a new owner could expect, which is what we will use to make an informed offer to the seller.