In small to medium-sized businesses when we talk about net profit, what we really mean is that the net profit Plus the total of all the perks the owner derives from the business. Unfortunately, many of these perks are not legitimate business expenses and are therefore lumped together with other legal expenses in the income statement.
So, to determine the actual net profit, a buyer would add together the net profit and owner’s salary plus all the perks he receives, that is not actually running expenses of the business.
For instance, in the case of a restaurant, the owner might pay for all his family’s costs such as food and clothing out of the business including the running of his car, his retirement annuity, home and life insurance, along with a host of other personal expenses. This is seen as one of the benefits of being your own boss and taking all the risks and stress in running your own business. Whereas an employee you just have to worry about covering your expenses out of the net salary you receive.
The problem comes in verifying the actual net profit. Even when presented with an audited set of financials, a prospective buyer or his financial advisor may have to reconstruct the income statement removing the perks from the expenses to prove the net profit the seller claims he is making.
This is the easy part. The difficulty comes in verifying the cash sales the owner claims he is doing and not declaring. This is illegal and is defrauding SARS and my advice is that you can’t have your cake and eat it. If it’s not verifiable, then it should not be taken into account when determining the price, however, it is taking place.
There is one last increase to profits that can be allowed for in the SME market, called EBITDA Profits, a mouth full which means: Earnings Before Interest, Taxation, Depreciation and Amortisation. Basically, the profit used is before allowing for taxation then you can add back the interest and depreciation in the expenses to the profit.
So, in summing up when you see an advert of a business for sale, the profit shown is an EBITDA Profit, profit before taxation and includes interest, depreciation, the owner’s salary and all the perks he receives from the business. This is the amount used for valuation purposes.
This is part of the series A-Z in Buying a Business by Mike Hindle of Affiliated Business Brokers.