Net income is a figure that tells you how much money a business is making, or does it? Though in theory net income is supposed to tell you exactly how much money a business made, for small businesses it is not always the case. Making it more confusing is the use of various variant formulas used by commercial realtors to describe the profitability of specific businesses in their marketing efforts. There are some basic considerations that are useful in determining a business’ profitability.
Profitability is the difference between revenues and expenses; what the business receives from its customers and what it pays in order to deliver the product or service. “Cash flow”, “operating cash flow”, “cash from operations” and related terms refer to the difference in the actual cash held by the business for the year (or whatever period being looked at). Profitability is the true measure of profitability because it accounts for the portion of the business’ assets used in producing the sales for a given period.
Commercial realtors often use cash flow, or related terms for marketing a particular small business because it is a larger figure than that of profitability and makes it seem like the business is much more viable than it may actually be. In many cases, a business showing a positive cash flow may be losing money and be a poor investment.
When calculating profitability of a small business, include the following considerations:
Revenue – Examine revenue, its source and nature. Revenue only counts if it is from the regular or ordinary operations of the business. If there are items of a non-operating or extra-ordinary nature (revenues from a special one-time opportunity, such as rental of premises by film production company, and gifts or incentives from suppliers), then remove them out of revenues because they are one-time items and you can’t count on them repeating in the future.
Expenses – Income statement should include all items used in the manufacturing, marketing, distribution and sales of the product or service. Draw a business process map and list all the steps and items required to supply the product or service and then make sure there is a cost line for each item. One of the biggest mistakes made is not including all the labour costs under expenses, especially when it is an owner operated business. If the owner manages the business regardless f whether he is drawing a salary the cost of paying someone a competitive wage to do his job should be included in expenses. This also applies to any family members that are working the business – their wages (at market rates) should be deducted as an expense.
Non-Business Expenses – Sometimes an owner may include items under expenses that may not be necessary or appropriate to include. For example, automobile expenses for a business that doesn’t require an automobile. For the purposes of calculating profitability for the sale of the business, these items should not be removed as an expense.
Depreciation and Amortization – In many cases, a business uses equipment (such as in manufacturing), leasehold improvements (such as restaurant and retail), and other assets (such as trees in a tree lot). Once these resources are used they have to be replaced. For that reason it is important to know how much of the resources value you consume for the production of what you’ve sold for the period and to include it as expense lines.
If you incorporate these considerations when calculating cash flow you’ll soon realize that most small businesses for sale are actually losing money. This is often the reason, or at least contributing factor in their decision to sell.
These considerations will help you determine the true profitability of the business according to the financial statements of the company. However, be aware that you are basing your calculations on figures provided by management or the owners. It is quite likely that these figures aren’t totally accurate. If you decide to purchase the business, then it would be wise to conduct or have conducted detailed due diligence by someone who knows what to look for.
Be detailed in your understanding of the business and examination of all aspects of operations and you should end up with an accurate profitability figure. Only then can you decide what the business is worth to you.
By Baldo Minaudo, M.B.A. (www.baldominaudo.com), author of “The Banker Who Saved His Soul” (www.baldominaudo.com).