What are a business seller’s discretionary earnings?
It is NOT the profit or loss that a business owner shows Uncle Sam on the tax return. To put it delicately, almost all business owners run some expenses through the business that are not — a’hem – absolutely necessary to the operation of the business.
Seller’s discretionary earnings (SDE) are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary earnings is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business.
More formally, seller’s discretionary earnings (SDE) is the amount of cash left over after paying only the necessary operating expenses that is available for (1) owner’s salary and benefits, (2) return on investment and (3) debt service, if any.
To illustrate, let me tell you about the sale of a restaurant that I handled as a business broker several years ago. The profit and loss statement from the business was actually showing a small loss.
However, the owner’s wife drove a Lincoln Navigator which was listed on the books of the business as a company vehicle. The company also paid for all her gas and maintenance on the Navigator although she had no role in the operation of the restaurant. Same for the daughter’s Honda which she drove back and forth to college. The daughter was also on the payroll as an employee of the restaurant which furnished her with spending money at college, although she never actually worked at the restaurant.
The family’s ski vacation to Colorado was charged to the business because the owner attended a business meeting for a few hours while in Aspen. You see where I’m heading here, don’t you? By the time all these items plus any non-cash expenses (eg: depreciation) were accounted for, the restaurant was actually producing a nice yearly cash flow for the family.
DISCLAIMER: Hey, I’m not with the IRS and don’t render an opinion on these sort of things!
In addition to the owner perks discussed above, non cash deductions like depreciation are added back to the net profit shown Uncle Sam, as are one time expenses not likely to recur (eg: an air conditioning system being replaced).
CPAs and business brokers often refer to the computation of discretionary cash flow as normalizing or recasting the company’s profit and loss statement.
Why is the computation of discretionary cash flow important?
It provides an accurate picture of the true cash producing ability of the business. In effect, it uncamouflages the bookkeeping practices of most business owners.
And since many business appraisals are done based on the seller’s discretionary earnings, it’s important to be able to accurately compute the number.
Here’s an article explaining the differences between seller’s discretionary earnings (SDE) and earnings before interest, taxes, depreciation, and amortization (EBITDA). It’s an important difference that often causes confusion.
If I can help with any questions or computations on this subject, don’t hesitate to contact me.
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