Lesson 12

Steps in Completing the Reconstruction of Profit and Loss Statements


Welcome to lesson # 12 Who Wants To Be The Boss? I’m excited to have you as a valued member of our 6-month training program and am looking forward to seeing your own “business” “come to life” over the next few weeks and months.
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Steps in Completing the Reconstruction of Profit and Loss Statements:

1. Start this process by going over each expense on the profit and loss statement for the most recent year. You want the net, pre-tax profits. This comes directly from the financial statements and, or IRS returns. Be sure that the revenue reported was actually created by the business.

2. Owner’s Wages: This will include salaries, payroll taxes and bonuses of the owner or owners. You should add this back to cash flow.

3. Vehicle Expenses: It’s not unusual for a business to provide a car or a vehicle allowance to the owners or manager. This expense should be added back, along with other related vehicle expenses such as insurance, repairs and gas and oil. Also watch out for vehicles furnished to other family members or employees.

4. Entertainment Expenses: You can be sure there will be owner entertainment expenses; travel, conventions, meals and organization dues. You should add this back to the cash flow.

5. Owners Personal Insurance: You need to add back to cash flow owner’s life, hospitalization and all other insurance that benefits the owners.

6. Non-Working Employee’s Wages: Sometimes a wife, son, daughter or brother may be on the payroll but not actually working in the business. Example; son or daughter going to college and works only a few hours in the business, but gets paid full time. Add this back to cash flow. Also watch out for over compensated employees, such as wives or husbands getting paid higher than the position justifies. The amount that’s over paid can be added back to cash flow.

7. Depreciation: Be careful here. You’ll get a variety of numbers from the owner or broker. For your reconstruction purposes, you’ll be dealing with excess depreciation over what is actually needed to cover replacement costs. Most businesses do this but many times it is not an actual expense. Add back.

8. Amortization: The best way to describe amortization as depreciation of intangible assets. It’s spreading out of costs over a period of time like depreciation. It is different from depreciation in that depreciation usually refers to physical assets where amortization applies to things that expire, (Notes, mortgages). Add back.

9. Interest Expense: Do not add back the interest expense incurred by floor planning or any promissory note that will be assumed directly or wrapped. However, the total expenses for interest payments should be added back. If you are buying the stock of the corporation, the interest expense is not added to cash flow because these interest payments will continue.

10. One Time Major Expenses: An example of these expenses would be; Major repairs to business property or vehicles, if the cost was expensed instead of capitalized. Fees related to litigation. Add back.

11. Bank Charges: Look for lines of credit with monthly interest payments. As a new owner you won’t have this so it should be added back to cash flow.

12. Fines and Penalties: Any fines or penalties imposed by any governmental agency should be added back to cash flow.

13. Rent: You have to determine your rent expenses. If the owner owns the building and property and leases it to the business, you need to find out if the rent will be less than he is currently charging himself, then the difference will be an add back to cash flow. If he is going to charge more, there will be a deduction of the difference to the cash flow.

14. Other Expenses To Look At: Sometimes you’ll find a corporation will be leasing the property from the owner or a major stockholder who includes the property in the sale, the rent then becomes an addition to cash flow.

15. What Must Be Deducted From Cash Flow:

A. Other Income: Any income that will not be available to you. If revenue was generated by selling assets or unusual activities or came from sources other than the business, deduct those amounts. Also non-recurring income or one time income.

B. Gains and losses on Sale of Assets: If a loss occurs, it is an add back to cash flow. If a gain made on the sale of an asset, the income must be deducted from the cash flow.

C. Interest Income: If the owners received interest income, deduct this amount from the cash flow. You will not receive this income because the owner will be keeping the cash that created the interest.

D. New Rent Expenses: When the Seller owns the property and the real estate is not included in the sale to the new owner, but will be leased back to the new owner, the amount of the rent payments must be deducted from the cash flow.

In addition to reconstructing the profit and loss statements of the company, it is important to examine the balance sheet and make those adjustments to show the fair market value of the company’s assets. The value of the assets listed on the balance sheet are usually based on the best tax advantage for the company, meaning that as much depreciation as is allowable has been written off, thus allowing the owner to pay less taxes and lowering the value of the assets.

These assets should be revalued for your evaluation to show the true market value. Also, you need to find those assets that have been written off but are still part of the company and are still in use. In this lesson, How Much is the Business Worth, I am not attempting to cover all aspects of reconstructing or analyzing financial statements nor am I suggesting that these formulas are foolproof.

This lesson is designed to give you a start on evaluating a small business. Look at what the company is likely to do in the future, its ability to pay a payment to the seller, pay you a wage and have a little left over to put back into the business. There must be enough cash flow to accomplish the payment on return of investment and service the debts. Use as much professional advice and common sense as possible.

Valuation Formulas

The following two formulas will give you a quick and easy ballpark figure to calculate the value of the business you are proposing to acquire. Again, keep in mind, these are guidelines that work for me. These methods used to value a business are based on cash flow and assets only. There are other factors that influence the value of a business. These formulas will give you a ball park value of the business. They will help you meet the Seller somewhere in the middle and give you the opportunity to start your unreasonable negotiation process.

In the first formula, you will add the assets to be included to the cash flow. Add the accounts receivable separately into the formula only when it doesn’t include accounts payable. I always try to include accounts receivable into the deal. I will show you why in the financial technique chapter later.

Example 1:

You have assets of furniture, equipment and inventory that total $100, 000. The cash flow of this business is $50,000.There is $25,000 accounts receivable you will receive.

Formula 1: Assets of $100,000 + Cash flow of $50,000 = $150,000
Formula 2: Cash flow of $50,000 multiplied by three = $150,000

Total of the two formulas = $300,000

$300,000 divided by 2 = $150,000

Add the accounts receivable $25,000

Approximate value of business $175,000

Using these formulas, the business should sell in a range of $175,000 to $200,000. Depending on the appeal of the business, the terms that are being offered and how motivated the Seller is, move up or down. Some businesses have better buyer appeal than others. By the time you get to this stage you should have a pretty good idea of your timing.

Example 2: In this example you will want to reverse the amount of assets and cash flow used in Example 1: You have assets of furniture, fixtures, equipment and inventory that total $50,000. The cash flow of this business is $100,000. There is $25,000 in accounts receivable you will receive.

Formula 1: Assets of 50,000 + Cash flow of $100,000 = $150,000
Formula 2: Cash flow of $100,000 multiplied by three = $300,000

Total of the two formulas = $450,000

$450,000 divided by 2 = $225,000

Add the accounts receivable $25,000

Approximate value of business $250,000

Using these formulas, the business should sell in the range of $250,000 to $275,000. Again, depending on the appeal of the business, the terms that are being offered and how motivated the Seller is, move up or down. Some businesses have better buyer appeal than others do. By the time you get to this stage, you should have a pretty good idea of your timing. As you can tell in example number 2, cash flow outplays assets in overall value.

As a buyer, you are trying to decide if there is enough cash flow to service the debt, pay you a reasonable salary, give you a return on your investment and leave some leftover to re-invest into the business. These two examples show the importance between assets and cash flow. I want to see a good cash flow in determining the amount of money the business will produce above the value of its assets.


This Week’s Assignment

Study the evaluation formulas. Fine businesses that are for sale and evaluate them using this lesson. You don’t have to tell any one what you are doing. This is just practicing. It’s a real eye opener when you start to understand how to evaluate a business.

I hope you are starting to get excited about buying or starting your own business! This is an exciting time. There has never been a better time for you to be your own boss! Think about it every day. Don’t let your dream slip away! If you want personal coaching go to dave@whowantstobetheboss.com/coaching.html

See you next time.

Hold on tight to your dreams

Dave Meholovitch


Coming Up Next…

Lesson #13: “Lock Up Your Checkbook, You Won’t Need It”
In this lesson and in several up coming lesson you are going to learn financial techniques that take the place of having to use your own money as a down payment. Whether you’re starting your business or buying. Stay tuned. I will share 16 different financial techniques with you.