Buying a Business in Texas – Define Earnings and Profits First

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When looking at buying a business in Texas and other parts of the U.S. there are many different terms used and the same term can be defined differently depending on who is using the term.

In this post I’ll try to define some of the terms commonly used to represent the “earnings” or “profit” the business generates.

The terms below are attempting to describe the operating profit available to the new business owner when the selling business owner, and all of the selling business owner’s non-business expenses, leave the business. Keep in mind that the vast majority of small business owners do their accounting with a single intent, minimizing taxes owed.

Here are some common terms you will see when looking at businesses for sale:

Cash Flow (CF or C/F) – This is a commonly used term for representing the “earnings” of the business and is definitely not the same definition of cash flow that a CPA would use. A CPA would include changes in accounts receivables, accounts payable, capital expenditures and a number of other items when calculating the true “cash flow” of a business. When you see the term “cash flow” used on Business for Sale sites what they likely mean is the “Earnings Before Interest Taxes Depreciation and Amortization” (EBITDA) plus Owner’s Compensation. Once you understand EBITDA and Owner’s Compensation you’ll have the code for the other definitions.

Net Income – Net income is a fuzzy one because lots of people include and exclude items that others might not find appropriate. You’ll have to have the person claiming the net income number explain EXACTLY what the source of the information is and what is included and excluded.

EBITDOC – This is a term I have created that I’m hoping the industry adopts. This was explained above when you piece together EBITDA and Owner’s Compensation. It’s the business earnings before interest, taxes, depreciation/amortization and owner’s compensation. With this definition it allows you to focus on the most critical of the elements which is proving the claims of the Owner’s Compensation, in all it’s forms. Many small business owners are very creative with their accounting. Make certain you understand the source and veracity of the numbers before you make any decisions.

EBITDA – This is a common measure of earnings in larger businesses but is less useful when buying a business in Texas. This earnings definition assumes that the “owner” or CEO of the company is receiving fair compensation for the job being performed and therefore no adjustments need to be made. This is rarely the case in small businesses for sale and therefore EBITDA, without Owner Compensation adjustment, is generally useless in evaluating the small businesses earnings. You will however see some representations of ebitda that make total sense as a stand alone number if embedded in that EBITDA number is an reconciliation for owners compensation. This number is often called Adjusted EBITDA.

Pre-Tax Income – This term is generally useless when evaluating the earnings of a small business. The problem is all of the non-cash entries and the owner compensation entries that happen before the pre-tax number is established. Often times this pre-tax number is manipulated so that the business owner reduces his taxable income.

The takeaway for this is that when evaluating buying a business in Texas or other places in the U.S. you need to take the time to understand how the advertised earnings were established and understand the items included. Don’t assume one business broker’s earnings is calculated the same way as another business broker, do your homework.

The Value Goes to the Prepared.

earnings of a small business.

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