Non-business items

A private business is a useful vehicle in which non-business expenses can be charged to provide benefit to its owners. Such matters as private motor vehicle, travel and telephone expenses are often included in business expenses and should be eliminated to arrive at real profit.

Non-recurring items

Where a business has any income or expense that is not likely to recur in future this should be removed from the published accounts to arrive at real profit.

Owners’ salaries

In calculating real profit it is sometimes necessary to deduct owners’ stated salaries from published profits and to replace them with salaries Ibased on market rates) which would be payable to managers undertaking equivalent work to the owners. Simply, you could ask what the business would need to pay on the open market for managers to undertake the owners’ current management tasks. This is also a useful guideline for an investor/purchaser who does not intend working in the business, as real profit can be calculated for the circumstances where an employed manager will be running the business.

Premises

Where the business owns the premises in which it operates, ownership can reside in different legal entities controlled by the business owner. In these circumstances rental is sometimes completely excluded from published business accounts, or charged at excessive amounts to move profits from one business entity to another.

In calculating real profit it is important that a true market rental figure is included in the business’s accounts. The true market rent should be easy to establish. Advice can be sought from your local estate agent if you have any doubts.

Cost of goods sold and gross margins

It is easy to manipulate the profit of any entity that purchases goods by adjusting the value of the closing stock in the accounts at period end. A business can achieve continuously increasing published profits merely by increasing the value of its closing stock. Conversely, a business can often eliminate its profit by writing down the value of its closing stock.

In calculating real profits, an amount needs to be added to or subtracted from the accounting profit to allow for any unrealistic valuation of stock.

Valuers usually qualify their valuations by stating the circumstances under which the valuation is being undertaken. For example, is the valuation of the business as a ‘going concern’, or for a close down, or for the sale of assets under duress (i.e. in a ‘fire sale’)? These circumstances can dramatically affect value as they could determine the presence or otherwise of goodwill value and the price received for individual assets.

For example, the value of fixed assets can be greatly reduced in a ‘fire sale’ when they are moved from their original premises and sold individually, rather than all together as a complete operating unit. In most cases of exit planning the owners of a business will be considering value as a going concern, but it is useful to be aware of the impact an exit through a close down (particularly a liquidation) could have on your business’s value.