Add-backs and normalised profit: how sellers adjust the figures, and how buyers check them

Small businesses are usually priced from their profit, but the profit in the accounts is not always the figure a buyer should rely on. Sellers adjust it with add-backs and deductions to show what the business would earn for a new owner, and buyers test those adjustments before making an offer. For the valuation methods themselves, start with how small businesses are valued.

What normalising profit means

Accounts are prepared for tax and for the current owner. They can include costs a new owner would not have, such as the owner's private car, and leave out costs they would have, such as a wage for work the owner does unpaid. Normalising adjusts the figure to show what the business earns in an ordinary year under a new owner:

• Add-backs increase profit by removing costs that will not continue.
• Deductions reduce profit by adding costs that are missing or understated.

business.gov.au lists using net profit to work out value as a common valuation method. When a price is profit times a multiple, every dollar of adjustment is multiplied too.

Common add-backs

Each add-back should be a real cost, recorded in the accounts, that a new owner will not pay.

• The owner's wage and super. This depends on the structure. The ATO says sole traders and partners do not have to pay super guarantee for themselves, while employees, including company directors, generally are eligible. So one business may show the owner's wage and super as expenses and a similar one may not. Adding them back puts both on the same footing, before the cost of replacing the owner is deducted.
• Personal expenses paid through the business. A private car, phone or travel. Only the private part is an add-back: if the car also does deliveries, part of it is a business cost.
• One-off costs. A settled legal dispute, a refit, a relocation or an unusual repair, but only if it genuinely will not recur. If a refit is added back, ask when the next one is due.
• Interest and depreciation. Moving to EBITDA adds back interest, tax, depreciation and amortisation. Interest reflects how the current owner financed the business. Depreciation is not a cash payment, but equipment still wears out, so allow for replacing it.
• Family members on the payroll. If a relative is paid more than the role is worth, or for a role that does not exist, the excess can be added back. A relative working for little or nothing does the reverse: profit looks higher than it is.
• Rent paid to a related party. If the owner or a related entity owns the premises and charges above market rent, the excess may be added back, but only if the rent under the buyer's lease will be lower.

Common deductions buyers make

• A market wage for the owner's role. Count the hours the owner works and the roles they fill, then price a manager or staff to cover them at market rates. Include on-costs such as super guarantee, which the ATO says generally applies to all employees, including family members working in the business. Even if you will work in the business yourself, your time has a cost.
• A market rent. If the owner owns the premises and charges little or no rent, deduct a market rent. What matters is the rent under the lease you will sign.
• Family and staff paid below market. Use what you would pay someone else to do the same work.
• Deferred costs. Maintenance, servicing, repairs or marketing the seller has put off. Spending held back before a sale flatters profit, and the bill arrives after you take over.

A worked example

The figures below are invented round numbers to show the arithmetic. They are an illustration only, not typical of any business or industry.

• Net profit in the accounts: $100,000
• Add back the owner's wage and super: $70,000
• Add back private vehicle and phone costs: $10,000
• Add back legal costs for a settled dispute: $20,000
• Owner's benefit for one full-time working owner: $200,000
• Less a manager's market wage and super: $90,000
• Normalised profit with a manager in place: $110,000

Both figures can be honest: $200,000 for an owner who does the work, $110,000 for one who pays a manager. At an asking price of $300,000, the Multiple would be 1.5 on the first figure and about 2.7 on the second. Neither is a benchmark: the point is that the profit basis changes the number.

A buyer would ask for the payroll records, the vehicle logbook and bills, and the legal invoices. If the dispute is still running, or the vehicle also does deliveries, those add-backs shrink.

How buyers test add-backs

Ask for a written schedule of each add-back by year, with the amount and the evidence, and review it with your accountant.

• Find it in the accounts. An add-back must match an expense in the profit and loss statement. A cost that was never deducted cannot be added back.
• Check the source documents. Invoices, bank statements and payroll records show what was paid and to whom. Compare them with the tax returns and Business Activity Statements. business.gov.au suggests examining three to five years of financials, including tax returns, BAS and profit and loss records.
• Ask whether the cost will genuinely stop. If the owner's car is the only delivery vehicle, you will need one too.
• Compare the years. Add-backs that appear every year, or grow as the sale approaches, need explaining.

Our due diligence guide and checklist cover the rest of the financial review.

Red flags

• Add-backs without evidence. If the seller cannot show a cost was paid and was personal or one-off, treat it as a business cost.
• Unrecorded cash. Takings said to be higher than the books show cannot be verified.
• "The business could do more if." Potential is yours to earn. Paying for it means paying the seller for work you will have to do.
• Repeated "one-offs". A cost that turns up every year is a recurring cost.
• The owner's work added back with nothing deducted. Someone still has to do it.

A note on personal expenses and tax

Personal expenses run through a business are also a tax question. Under the ATO's rules for business deductions, the expense must be for the business and not for private use, only the business portion of a mixed-use expense can be claimed, and you must have records to prove it. The ATO also notes that private company benefit rules and fringe benefits tax may apply when a business provides benefits to employees, shareholders or their associates.

So costs a seller now calls personal may have been claimed as business deductions. Sellers should get advice from their accountant before presenting them to buyers, rather than assuming the original claim was proper. Buyers should have their accountant review the schedule and, if buying the company itself rather than its assets, ask their solicitor and accountant whether past treatment could affect them.

Profit bases on listings and the Multiple

BizExchange listings label the profit basis, and each relates to normalised profit differently.

• Owner's benefit is normalised profit before any wage for one working owner, like the $200,000 above.
• EBITDA is profit before interest, tax, depreciation and amortisation. Ask whether a wage for the owner or a manager has been deducted.
• Net profit is profit after all expenses. Ask whether it includes an owner's wage and whether any add-backs have been applied.

The Multiple on BizExchange cards is the asking price divided by the published profit, and shows n/a when either is missing. It is a quick comparison, not a valuation. A business listed on owner's benefit shows a lower Multiple than the same business listed on profit after a manager's wage, so compare like with like and use the enquiry form to ask for the add-back schedule. See how to read a business for sale listing.

Sellers: say which basis you used when you list your business, and have the evidence ready. Preparing a business for sale covers your records, and What's my business worth? gives a quick estimate.