Every business generates a certain amount of profit or loss. However, not every business calculates this profit in the same manner. Discretionary earnings calculations help sellers and buyers make sure they’re on the same page in terms of cash flow.
A private business owner with no immediate plans to sell has an incentive to report lower profits, thus reducing taxes. This is often accomplished by writing off costs such as owner salary and health insurance as business expenses. These expenses are sometimes referred to as discretionary expenses because they are not necessary for business operations; therefore, they can be expended at the owner’s discretion. When it comes time to sell, the business owner has an incentive to do just the opposite. Non-necessary costs such as owner benefits and one-time expenses can be “added back” to profits without distorting the performance capability of the company.
Discretionary earnings are reached by recasting financial statements to remove the financial benefit received by a business owner. Typically, this means adding figures such as owner salary, pre-tax net income, owner perks, interest, non-cash expenses such as amortization and depreciation, non-operating expenses, and one-time expenses. Many small to medium businesses rely on DE to calculate earnings, while larger companies tend to use another measurement, EBITDA (or Earnings Before Interest Taxes Depreciation, and Amortization). EBITDA produces a similar result but excludes owner benefits such as salaries and perks, which usually only apply to smaller, privately-held companies.
For buyers, discretionary earnings and EBITDA strip away variables to reveal cash flow – and, in theory, a company’s true earnings potential. This is especially useful for financial buyers valuing a limousine business or other transportation company. Your sales price will likely be based on a multiple of your discretionary earnings. But although DE is a frequently used calculation method, it doesn’t always produce the same results. It’s not uncommon for business owners to get carried away, adding back expenses that cannot legitimately be categorized as profits. Misrepresenting profits can confuse a buyer, derail a sale, and, in the worst case scenario, serve as grounds for a lawsuit.
When recasting financials for your limo or charter bus business for sale, it helps to consider what costs a new owner would need to incur to produce your current cash flow. If the expenses are necessary, they must remain as expenses. If they truly are discretionary, it may be possible to add them back. Whether you’re buying or selling a limo business or a school bus company, a qualified transportation business broker can determine a fair value so you and a buyer can agree upon a fair price.