In the purchase or sale of a small business we generally come across a term know as Seller’s or Owner Operator(s) discretionary income.
Seller discretionary earnings is perhaps the best measure of profits that the business earns for the purpose of valuing the financial performance of small businesses and it is a concept that is used very often throughout the field of business brokerage and business valuation. This measure allows for the buyers of the business to make an informed comparison whilst eliminating the noise that can distort the financial performance of the business.
For those unfamiliar with, how is Seller’s Discretionary Income calculated, it is determined by adding to pre-tax net profit the wages for principal owner/manager (or salaried manager) including bonuses and any personal insurance premiums paid through the business. To this total, we add the non cash expenses of amortization and depreciation and all interest paid on long-term debt. Additionally we also include all expenses not necessary to run the operations of the company generally categorized as “owner’s discretionary expenses”, these expenses typically include such things like the owner personal car expenses, personal travel and entertainment and so forth all expenses enjoyed personally by all of the owners and their family members. If there are any non-recurring expenses (not capital expenditures) such as a one time uninsured loss, an extraordinary repair expense and costs of that nature should be added to the total and any non recurring income should also be deducted.