As someone who always seems to have a due diligence or two happening at any one time, I have learnt that net profit has far more authority than it deserves. It sits proudly at the bottom of the financial statements looking like the final answer, while everything that happened above it is treated as unnecessary background information.
Take a business showing net profit of $15,000. The buyer is immediately tempted to say, “Not interested.” Why buy yourself staff, rent, machinery, customer complaints and personal guarantees just to earn less than an entry level wage?
Then we look a few lines above and discover that the two owners paid themselves $250,000 each. The business did not simply generate $15,000. It generated enough to pay the owners $500,000 and still leave $15,000 behind. That sad little profit has suddenly become $515,000 before allowing for the commercial cost of replacing the owners’ work.
Nothing changed in the business but we simply noticed where the money had gone. It was not missing, stolen or lost through poor trading. The owners had taken it home every fortnight and called it wages.
The reverse happens too. An owner pays themselves almost nothing, works every available hour and leaves the money in the business. The profit looks magnificent, mainly because the financial statements have valued the owner’s time at approximately zero. Add a commercial replacement wage after settlement and some of that magnificent profit disappears rather quickly.
Owner wages are only one adjustment. Due diligence may also uncover personal motor vehicles, family members on the payroll, private travel, interest, depreciation, one off legal costs, unusual repairs and expenses that will not continue under the new owner. Some are genuine add backs. Others are merely expenses the seller has become emotionally opposed to recognising. Once a business is for sale, almost every expense suddenly becomes “one off.”
This does not mean every dollar gets added back and everyone goes home happy. Someone still needs to perform the owners’ work, depreciation may reflect assets that will eventually need replacing and yesterday’s “one off” expense has an unfortunate habit of returning next year. The purpose is not to manufacture a better profit but to work out what the business genuinely earns under normal ownership.
That is why looking at net profit without understanding owner wages and other add backs is almost useless. A business showing $15,000 may genuinely earn only $15,000, or it may have already paid its owners half a million dollars and absorbed several expenses that will never affect the buyer.
The line reading “net profit” should never be the end of a due diligence conversation. It should only be the beginning…