Valuing a Small Business – Determining Its Earning Potential
Valuing a small business requires more than just looking at tax records. It’s also important to consider its location, how it’s being managed, and whether or not it has a good financial track record. Assuming the first two factors are favorable, a close examination of financial history, including its trend in sales, can be a strong indicator of its earning potential.
After all, you want to know how much money you could earn for yourself once you take over the business. The financial history of a business will help you determine how much money the business is actually making (not for tax purposes). It will also help you determine the owner’s benefit, which is how much the owner is making for his or herself, minus the cost of running the business.
4 steps to determining the earning potential of a small business:
1. Review the Financials and Determine the SDE.
The most common earning’s metric for valuing a small business is called Seller Discretionary Earnings (SDE). Generally, this is the net income before taxes, depreciation, amortization, interest expenses, and all other identified owner benefits irrespective of how a prospective buyer would view them. You may want to work with the owner to determine the SDE. For some, this is the most accurate representation of earnings as you can predict any expenses that benefit the owner.
Yet, most small business financials, including revenue and expenses are compiled with the intention of minimizing taxes. As a result, these financial records may not reflect the company’s true financial performance. In this situation, the owner will need to work with their accountant and have their financials formally recast or reconstructed to arrive at an income amount that is more reflective of the company’s actual earnings.
2. Ask the Seller Specifics About How Much the Business Is Earning.
To get further insight, ask the owner specifics about how much the business is earning for them and their family. This may include details on how sales are calculated, a breakdown of their operating expenses, or any adjustments they made when compiling their financials for tax purposes.
You may feel apprehensive about asking for this information. However, the seller should expect to be asked for this information. These are the same sorts of details that would be requested from their accountant or business broker. If the owner is serious about selling the business, sharing financials shouldn’t be an issue.
3. Use the Annual Gross Sales to Estimate the Owner’s Benefit.
Annual gross sales of a business can be determined through examining the business financial statements and tax returns. As a general rule of thumb, a small business owner should be making anywhere from 10%-20% of gross sales. Any businesses earning less than $1 million annually will veer towards 20%.
Here’s a quick example of how the owner’s benefit is calculated using gross sales:
Gross Sales - $1,000,000
- Less Inventory Costs - $300,000
- Less Labor Costs - $300,000
- Less Rent Costs - $100,000
- Less Admin Costs - $100,000
Owner’s Benefit = $200,000
Keep in mind that the owner’s benefit is what the seller is making now. If you were to purchase this business, you would subtract the new debt service of the acquisition and add what you would do to improve the business going forward.
4. Use the Selling Price to Estimate the SDE.
Generally speaking, looking at the business’ selling price may help you determine the seller’s discretionary earnings. For example, if the owner has an asking price of $625,000, you can safely assume that he or she has an SDE of $250,000 - $312,500.
However, don’t assume that a business isn’t worth purchasing even if it’s currently losing money. You’re purchasing a business for its existing and future earnings potential. For example, a business may be losing money because of poor management but it has well-trained employees, a great location and a fairly solid reputation. By purchasing the business as-is and improving its management, you could increase potential earnings and generate a very healthy profit in time.
Answering the Question, “How Much Money Can I Make?”
Once you have all the necessary financial information from the seller, broker or accountant, you can gain a better understanding of how much the business is currently earning. Factor in its location, how it’s being managed and what could be done to improve or expand the business.
If you decide to purchase the business, consider any expenses involved with making the purchase, plus any possible improvements that need to be made. Factor in projected growth and you’ll have an idea of your future earning potential. For more information on valuing a business, read our article, 6 Rules of Thumb for Business Valuation.