How Profitable is Your Business….Really?
If you don’t know how profitable your business is, you are not alone. Few business owners do. 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.
Accounting follows the money. It doesn’t tell you how much money you are making. At least, not without some digging around the numbers. Asking the right questions. Making proper adjustments.
So, why is this important? If you don’t know profits, you can’t know value.
• Market value rests on the buyer’s estimate of future profits.
• Estimated future profits rely on past profits (amount and trend).
• Thus, past profits drive market value.
So, how profitable is your business?
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” found not quite at 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
This is a simplified example. Any non-operating or non-recurring revenue and/or expenses would require additional adjustments. Multiple owners or a non-full-time single owner would also require additional adjustments.
By calculating discretionary earnings, a business owner can easily know the real profitability of his or her business.