Add-Backs and Adjusted Profit Explained

Key Takeaways

• Adjusted profit restates reported profit to show what a new owner could expect to earn from the business.

• Adjustments can increase or reduce profit, and buyers may look for both.

• Every adjustment needs a clear reason and a document behind it.

• Owner and family wages, private expenses, related-party rent and one-off items are common categories.

• An accountant should review the schedule before it goes to buyers, because it can feed into the sale contract.

Financial statements are prepared for tax and compliance, not for a sale. They reflect the way the current owner runs the business, including the wage they pay themselves and the costs they choose to put through the accounts.

In a business valuation, adjusted profit removes that personal layer so a buyer can see the earning capacity of the business itself. The individual changes are called adjustments, or add-backs, and they are generally reviewed as part of a business appraisal before the business is marketed.

Buyers reviewing a business for sale on the Gold Coast will generally ask how the adjusted figure was reached. A broker for selling your business works with your accountant so each adjustment is documented and can be traced back to the accounts before the business is marketed.

What Adjusted Profit Shows

Buyers price a business on the profit they expect to receive after settlement, not the figure on the last tax return. Adjusted profit bridges the two. It starts with net profit in the financial statements, then adds or deducts items that will not continue in the same form under a new owner.

Business brokers on the Gold Coast generally prepare an adjusted profit schedule as part of a sale appraisal. A buyer's accountant may prepare their own version during due diligence. Where the two versions differ, each difference may need to be explained and supported.

The measure used matters. Small owner-operated businesses are often assessed on earnings before the owner's wage, sometimes called seller's discretionary earnings. Larger businesses with a manager in place may be assessed on earnings after a market-rate wage for that role. The schedule should state which measure it uses so the buyer compares like with like.

Adjustments Go Both Ways

Add-backs are usually described as items that increase profit, but adjustments can increase or reduce profit. A schedule that only moves one way may attract closer scrutiny.

Upward adjustments remove costs the business will not carry after sale. Downward adjustments add costs the business should have carried, or remove income that will not repeat. Do not assume a buyer's accountant will accept only the upward items. Show both directions in the schedule before the buyer finds them.

Common Adjustment Categories

Most schedules draw on a small set of recurring items, each of which can move profit in either direction:

Labour Costs

The owner's wage is restated to what it would cost to replace the role. If the measure used is earnings before the owner's wage, it is removed entirely. Family members paid above the going rate for their work are adjusted down to a market wage.

Family members who work unpaid may be a downward adjustment, as a buyer would need to pay someone to do that work.

Private Expenses

Motor vehicles, phones, travel, insurance and subscriptions that are partly or wholly personal are common items. Only the private portion is adjusted. The business portion stays in as a cost.

Related-Party Rent

Where the owner also owns the premises, rent may sit above or below the market rate. The adjustment moves it to a market figure, in either direction. Where the buyer will sign a new lease, the rent in that lease is generally the figure that matters.

One-Off Items

A legal dispute, a major fit-out, storm damage, a bad debt from a customer that no longer trades, or the cost of preparing the business for sale can be removed where they will not recur. Routine repairs, regular marketing and staff training are ongoing costs and generally stay in.

One-off income is treated the same way. An insurance payout or a government grant that will not repeat is generally removed from maintainable profit.

Depreciation and Interest

Depreciation, interest and income tax are often removed because they reflect how the business is financed and structured, not how it trades. Where the buyer will need to replace ageing equipment soon, an allowance for that spend may be a reasonable downward adjustment.

What Buyers Accept

Buyers and their advisers generally accept an adjustment when three conditions are met:

• The item is clearly identified in the accounts, with the year and account line named.

• A document supports it, such as an invoice, a lease, a payroll record or a logbook.

• The reasoning holds for the buyer, not just the seller.

Adjustments are more likely to be rejected in three situations:

• They rely on memory instead of records.

• A cost described as one-off appears in every year.

• A cost cut shortly before sale is presented as a saving.

Buyers may also question an owner wage set below what it would cost to hire a replacement.

Worked Example

Illustration only. The figures below are hypothetical round numbers chosen to show the mechanics. They are not a market claim or a prediction, and no valuation multiple is applied.

The illustration rests on these assumptions:

• Reported net profit of $150,000 after an owner wage of $60,000.

• A replacement manager would cost $90,000 including on-costs.

• Private vehicle and phone costs of $12,000 sit in the accounts.

• A one-off legal dispute cost $20,000 in the year.

• The owner's partner works unpaid in a role that would cost $40,000 to fill.

The schedule works through each item in turn:

In this example the adjusted figure is lower than reported profit because the downward items outweigh the upward ones. Each line still needs a record the buyer can trace.

Documenting the Schedule

Present adjustments as a schedule, year by year, covering the same period as the financial statements supplied to buyers. A schedule that holds up in due diligence generally includes:

• One line per item, with the account name and the amount in each year.

• A short reason for each line.

• Supporting documents filed in the same order, ready for due diligence.

• Consistent treatment of the same item across years.

The earlier the schedule exists, the more useful any appraisal can be. The same adjustments apply when valuing a cafe or restaurant, where owner labour and premises rent are common items to review.

Where the Schedule Ends Up

Statements about adjusted profit can find their way into the information memorandum, and from there into warranties in the sale contract. If a buyer later shows an adjustment was wrong, the seller may face a claim. Financial information given to buyers may also be subject to the misleading or deceptive conduct rules in section 18 of the Australian Consumer Law.

Cleaning up the accounts well before listing can make the schedule shorter and easier to support. Fewer lines mean fewer items for a buyer to test, and that preparation is part of lifting business value before a sale.

Have an accountant review the schedule before it is released. Have a solicitor confirm how the contract treats financial information supplied before signing.

Build the Schedule Early

Start the schedule from the most recent full financial year and work back, so every adjustment is identified before a buyer asks. Then have your accountant check each line against its supporting document.

Bond Business Brokers can review an adjusted profit schedule as part of a confidential appraisal of your business.

Common Questions

Do add-backs change the tax I pay?

Add-backs present earnings for buyers and do not change tax returns already lodged. Some add-backs may show that private expenses were claimed as business deductions, which can raise a separate tax question. Speak to your tax agent before the schedule is released.

What happens if a buyer rejects an adjustment?

The buyer may reprice the business on their own view of maintainable profit, which can mean a lower offer or a request for further evidence. Supplying the document behind the item may resolve the issue. Where an item cannot be supported, withdrawing it may preserve the credibility of the rest of the schedule.

Is stock included in adjusted profit?

Stock is often dealt with separately from adjusted profit, commonly as an amount added to the price at settlement. Changes in stock levels between years can still affect reported profit, so ask your accountant whether any stock movements need restating in the schedule.

This article provides general information only. Obtain advice from appropriately qualified advisers about your circumstances before entering into a transaction or relying on tax, legal or regulatory information.