Net Income vs. Seller’s Discretionary Earnings (SDE): Key Metrics for Small Business Acquisitions
When it comes to small business acquisitions, understanding the right financial metrics is crucial for making informed decisions. A common question that arises is the difference between net income and Seller's Discretionary Earnings (SDE). While these terms are sometimes used interchangeably, they represent two distinct financial measurements. Knowing how to distinguish between the two can help you evaluate the true profitability of a business. In this guide, we’ll break down the definitions and the key differences to help you make smarter business buying decisions.
What is Net Income?
Net income is what a business earns after deducting all expenses, including operating costs, taxes, and non-cash expenses.
For prospective business buyers, it’s vital to verify how sellers calculate their net income. It’s important to review the profit and loss statement (P&L) carefully to understand the details of the revenue and expenses. You will see variances amongst P&Ls. For example, some P&Ls will include income taxes as an expense line item and some will not.
What is Seller's Discretionary Earnings (SDE)?
Seller's Discretionary Earnings (SDE) is a more useful metric for evaluating the earnings of a small business. Unlike net income, SDE normalizes financials by adding back specific expenses that may not reflect the actual operational costs of the business. This allows buyers to gain a clearer picture of the potential cash flow.
SDE is similar to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Both calculations take the net income and add back interest, certain types of taxes, depreciation, amortization, one-time spending, and discretionary spending. SDE also adds back the owner’s salary.
Taxes and Non-Cash Expenses: Impact on Net Income and SDE
Business owners can legally reduce their taxable income by writing off various expenses. Some of these expenses are things the owner paid for in order to maintain day to day operations, such as utilities, wages, and supplies. Additionally, there are non-cash expenses, such as depreciation and amortization.
For instance, if a business purchases equipment, the cost can be spread out over time through depreciation. A profit and loss statement may show a depreciation expense of $9,400, but that doesn’t mean the owner actually spent that $9,400 that month. That cost may result in a loss on paper, even if the owner did take home profit that month.
Add Backs: Accurately Comparing Two Businesses
A crucial component of SDE calculations is the concept of add backs. These are specific expenses added back to the earnings to better represent the business’s available cash flow. Common add-backs include:
Owner’s salary (if applicable)
Interest payments
Taxes
Depreciation and amortization
Non-recurring expenses
Discretionary spending
For example, if two businesses each generate $20,000 in monthly revenue, but one has a $1,000 interest payment and the other has no interest payment, the business with the interest payment might show a lower net income. However, since buyers typically acquire businesses debt free, the interest payment becomes irrelevant for the new owner and is added back to reflect a more accurate cash flow.
Scrutinizing Financials: Verifying Add Backs
While SDE can provide a clearer financial picture, it’s important to scrutinize the legitimacy of add backs. For instance, if a seller claims a one time consultant fee is a non-recurring expense, you should verify that this fee truly won’t be required again.
Ensuring that all add backs are legitimate will give you a more reliable sense of the business’s profitability and help you avoid unexpected costs after the purchase.
Conclusion: Why Understanding Net Income and SDE Matters
In summary, understanding the differences between net income and SDE is essential when considering a small business acquisition. By diving into the financials and thoroughly reviewing profit and loss statements, you can assess the true value of a business and its potential profitability.
If you’re looking to buy or operate a small business, understanding these financial metrics will help you make better investment decisions. Have questions or need more clarity on the topic? Feel free to reach out and ask us your questions!
