Many people want to know how much money does a business owner make. Surprisingly, most business owners don’t know either. This is a byproduct of our accounting rules and tax laws. While accounting may be the language of business, it’s a foreign language to most business owners. Standard accounting statements and tax returns do not provide the answer. Accounting follows the money. Consequently, it doesn’t tell you how much money the business is making. At least, not without some digging around the numbers, asking the right questions, and making proper adjustments.
Knowing Is Important
So, why is this important? If you don’t know the profit, you can’t know value.
1) Market value rests on the buyer’s estimate of future profits.
2) Estimated future profits rely on past profits (amount and trend).
3) Thus, past profits drive market value.
So, how can profitability be calculated?
Discretionary Earnings = Amount of Money a Business Owner Makes
While “profitability” can be defined in many ways, the most common measure of profitability is discretionary earnings. These are the earnings of the business available to one owner/operator before interest on debt, income taxes, non-cash expenses, owner compensation & benefits, and normalized for non-operating and non-recurring items.
The simplest way to calculate discretionary earnings is to start with pre-tax earnings (EBT). On the typical Quickbooks Profit & Loss statement, this is called “Net Ordinary Income” usually found just above the very bottom. Then, make the appropriate adjustments, as shown below:
Simplified Calculation of Discretionary Earnings
“Net Ordinary Income” (a.k.a. pre-tax earnings, earnings before tax, EBT)
+ Interest (on debt)
+ Owner Compensation & Benefits (for one full-time owner/operator)
= Discretionary Earnings
As this is a simplified example, not every potential adjustment is listed. For example, any non-operating or non-recurring revenue and/or expenses would require additional adjustments. Furthermore, multiple owners or a non-full-time single owner would also require additional adjustments.
By calculating discretionary earnings, the question of how much money does a business owner make can finally be answered.