Practices used to calculate normalized net income, and the misleading terms often used.

NORMALIZED NET INCOME

Determining the Normalized Net Income is the first and most important step in determining the value of your small business; any other term implying the same thing is suspect. (Small business being less than ten million dollars in sales.)

If you are reading financial information about a small company and you see the terms, owner's discretionary income, seller's discretionary income, seller's discretionary earnings, free cash flow, seller's discretionary cash flow or owner's cash flow, BE CAUTIOUS!  These are terms that people feel they can trust but in fact they are often very misleading. You may also see the term EBITDA, this is a legitimate term when used in the right context.

If these terms are used in relation to the sale of a small business, someone (usually the buyer) is being misled.  The manager's of banks and other financial institutions have been mislead by these terms so often that their head offices are often very skeptical about financing the purchase of a small business.

OWNER'S DISCRETIONARY INCOME:
This term will often be used for those trying to sell a franchise. They will show you a number like $75,000 per year; or perhaps even $90,000 for owning and operating something like a plumbing franchise.
What they do not make clear is that the $90,000 per year is BEFORE the owner/manager/PLUMBER is paid.
Depending upon where you live a plumber will probably make $65,000 to $85,000 a year just by going to work every day.

If the people selling the franchise were being truthful they would use the term NORMALIZED NET INCOME which would show the profit AFTER everything, including the owners wages, were paid out at fair market value. If the fair market value of the plumber's/owner's wages were $70,000 the true profit figure would be $20,000 NOT $90,000.

The perpetrators are generally white shirt and tie and go to great lengths to convince buyers they are professionals, and in a dark way that is true.

FREE CASH FLOW, OWNER'S CASH FLOW and OWNER'S DISCRETIONARY INCOME are all 'weasel' words used in the process of separating people from their hard earned money.

EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
Some industry groups think it is okay to include one owner/manager wage in EBITDA which results in the same misleading situation. You therefore have to be very careful in the context that EBITDA is used, most especially if dealing with small business and a deceitful sales person or owner is explaining the numbers.

EBITDA is generally used as a measure of a company’s operating cash flow based on stated earning from financial statements BEFORE interest, taxes, depreciation and amortization.

INSIST ON NORMALIZED NET INCOME

Reasons to insist on Normalized Net Income:

  • Is the rent paid at fair market value?
    This is a big issue if the business owners also own the building and property.
  • Are friends and/or family members working and not being paid market wages?
    This is sometimes done to boost the profits. Profit may also be hidden when the owner and/or staff receive company paid for perks that would not be given to regular employees.
  • All manner of discretionary items could distort the true profit or loss of a business.

Once the true NORMALIZED NET INCOME is established you will need to obtain a professional assessment on RISK and OPPORTUNITY to determine the ratio or multiple to use.  This ratio of the Normalized Net Income will determine the value of the cash flow, or what some people call the goodwill, of the business.

Next, one must consider HARD ASSETS and INTANGIBLE ASSETS.
These also figure into the value of a business.

I can think of a current situation where the INTANGIBLE assets are worth in the range of ten million dollars but none of this shows on the balance sheet.

I hope this information is helpful to you.

My niche is Small Business Valuations with special expertise in understanding intangible assets which are often missed as they don't show up on the balance sheet. In addition to financial statements, I take into account processes, procedures, the knowledge base of owner and employees, the value of employees (recruitment and training,) the value of the client base, internet presence and use, documentation and risk.

The rate of return on the real normalized net income is always the first and last consideration. Value to whom? The bank, the seller, the buyer (our valuations can include more than one.) This is why PIN Valuations are more accurate than most.

The process is this:

  • You provide me with the financials (3 years of Balance Sheet and Profit and Loss Statements.)
  • I will review the financials and then set up a convenient time to speak with you for intake and review.
    I can arrange a conference call if there are additional parties to be included.
  • I may need a secondary intake after I complete my preliminary review.
  • I do my analysis and write the report.
  • I send the valuation report to you for review to see if there are any errors or omissions to be corrected. If there are no revisions required, we are complete.

The turnaround time is estimated at one week from the time I receive your financials.

Regards,
Eric Jordan CPPA (President) Pin Services Ltd.
Head Office Victoria, BC
Virtual offices in Vancouver, Calgary, Edmonton, Winnipeg, Toronto, Ottawa and Halifax.

I work across North America.
Call for a free consultation, anytime.
1 800 606 0310

CURRICULUM VITAE

Eric Jordan President and CEO of PIN Services Ltd.
1027 Pandora Avenue, Victoria BC Canada V8V 3P6
1 800 606 0310

Education and Recent Courses:

  • Canadian Personal Property Appraisers Group at Toronto Canada.
  • Compliant with Universal Standards for Professional Appraisal Practices.
  • Ongoing Education WIPO (World Intellectual Property Organization.)

Memberships:

  • CPPAG

Work Experience:

  • Self employed since 1973
  • Founded pin.ca website in 1998 and have run it ever since; helping client base in Ontario, Manitoba, Saskatchewan, Alberta and British Columbia in Canada and some US States to sell small businesses.
  • Valuation was a large part of the workload over the past ten years most especially those businesses with intangible assets.
  • Sectors of experience include Oil, Agricultural, Manufacturing Transportation , Tourism, Wholesale, Retail, Service and Sales.
  • Support for Litigation in matters pertaining to business.