We’ve discussed this topic before on our site. We emphasized that the first step in selling your business is conducting a business valuation. We have also mentioned that one of the first steps in a business valuation is recasting your books. But what does this mean? How do you do it, when, and why?
The truth about most businesses and business owners is that they and their accountants do as much as possible for tax reasons to minimize business profitability. The reason is that the less money you make, the less you pay Uncle Sam at the end of the year. This makes sense due to the evolution of the tax code.
There is nothing wrong or immoral about this: why would you pay more taxes than you absolutely have to? The problem is that once it is time to value your business, most small business owners have forgotten how they and their accountants manipulated the numbers. This was done to make them work best for the IRS.
This means that over time, financial statements show less of the actual value of the business, making it appear less profitable. What does that mean to your business valuation? It means it could be significantly lower than it should be if you recast your books.
One caveat here: recasting your books does not always have a positive effect on your business value. If you have been paying your spouse or another family member to perform specific tasks at a rate below market value, you might have to include what you would actually pay someone to do those tasks in your recasting. However, for the most part, recasting your books will have a positive effect on your business value.
How do you recast your books?
Every business is different. So for some, there will be more work here than for others. Here are some everyday items to review during recasting.
- Inactive family members on the payroll. Perhaps as part of the deal when you inherited the business from your father, your brother collects a salary but does not actually do any work for the business.
- Vacations and trips that are not directly part of the operation of the company. Maybe you mixed business and pleasure and deducted that resort from your taxes. While that works for the IRS, it does detract from your business’s profit.
- Non-fair market rent paid to you for items the business uses, but you personally own. For example, let’s say you own the building the company uses, but you personally lease it to your business for more than fair market value for a business tax deduction. That rate will be reduced to a fair-market value in recasting.
- Assets on the balance sheet are not necessary for ongoing operations.
- Your salary is above fair market value. If you pay yourself a salary, including bonuses, that is above fair market value, it will need to be reduced in your business valuation to show the actual profit of your company.
- Potentially, the complete removal of an inactive owner’s salary.
- Duplicate overhead costs a new owner may eliminate.
- Consolidation of multiple locations.
The thing is, this is just a short list. Your accountant can help you with a more complete one, removing anything that is not directly related to the ongoing operations of the business.
Remember, the buyer of your business will be comparing your business to a variety of other opportunities. You want your business to look as desirable as possible. That means making sure they can see the true earning potential of your business, not what you want the IRS to see.
When do you recast your books?
You can recast your books at any time; however, this can be a costly and time-consuming process. What does that mean about timing? Well, there are essentially only two times when you want to recast your books: those are if you are getting a business valuation because:
- You are seeking financing or investors for your business.
- You are either considering selling your business or actively listing it for sale with a business broker.
In either case, you want to show what you are truly making for a profit to either a lender, a potential investor, or a buyer. You could recast your books just out of curiosity, but there is seldom a legitimate reason to do so.
Why recast your books?
We have touched on this point in the introduction and the portion on when to recast your books. But it bears repeating one more time.
Your current cash flow and other financial statements probably do not accurately reflect the real value of your business. Your profits may hide the actual performance of your business. This is not essential to the business’s everyday operation, but it does offer tax savings over the long run.
Recasting provides an economic perspective on the company as if it were run by management. Their focus would be on maximizing profitability. This means that instead of focusing on tax savings, your books will concentrate on showing the maximum profit possible.
This can set your business apart, allowing buyers to compare it with other opportunities. They can do so with a clear picture of the potential of your business to generate profits. After all, that is why you went into business. It is also why someone would want to buy your business.
Are you ready to sell your business or just looking for a business valuation? Rogerson Business Services can help, and we would be delighted to discuss how with you.
Feel free to contact us for a brief consultation and to get the process moving forward.