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.

Business value is normally arrived at by capitalising profits (or cash flows). Profits represent the purchaser’s return on investment and the reason he is prepared to pay the purchase price. But there are various types of profit, so what do we mean by the term ‘profit’ and what profit should be used in business valuations? There are three kinds of profit that you should know about, namely ‘real’ profit, ‘super’ profit and ‘future maintainable’ profit.

The published profit of a private business often gives a distorted view of the real profit of a business. This is because the business owners sometimes arrange matters so as to minimise taxation. On the other hand, some businesses will publish accounts that overstate their profits (or understate their losses) by not including expense items such as rent (where, for example, they own the business premises), or by understating the realistic cost of running the business by not including full salaries for business owners and their families. This can be due to oversight, or an attempt to overstate the value of a business.

In summary, published profits could be different from real profits because: Owners mix their private and business financial transactions. Profit is shifted between different business entities within the same group. In any one year there are non-recurring, or ‘one-off’ items included in the accounts.

The real profit of a business should be used to arrive at a true value of a business, whatever profit-based valuation method is being used.