Practical articles to help small business owners when selling and buying small businesses.

How to use your tax returns to increase business profits and value.

Michael Kerr - Sunday, March 03, 2019

A practical guide for using tax returns, management accounts e.g. MYOB or Xero and business activity statements to increase profitability and business value.

In my experience many owners see their obligations to complete the annual tax return and regular business activity statements only as a necessary evil. In other words, a massive compliance obligation.

You heave a big sigh of release as soon as you get these compliance obligations out of the way.

And then you get back to business before the next quarter or financial year end comes around.

While I don’t like the process anymore than any other small business owner simple analysis using the existing information in your tax returns and business activity statements can deliver some significant benefits.

The three main benefits of comparing financial performance over multiple years.

By following the simple process outlined below in this article you can;

  1. Better understand important trends in the financial performance over multiple years,

  2. More accurately pinpoint where the best opportunities are to improve financial performance leading to an increase in business value,

  3. Especially if you are thinking about selling, understand how potential buyers might value your small business.

Business buyers always look at long term performance and trends.

Approaching each compliance event e.g. your next annual tax return, purely as a compliance obligation shrinks your perspective on the ongoing performance and potential sale value of the business down to what happened last quarter or last year.

While most of you will have a very good idea of what’s in the bank and what money is owing or owed it’s still a long way off a true understanding of the financial performance and potential sale value of the business to a buyer.

Why is it important to look beyond the current bank balance and the last quarter or last years performance?

The answer is that any meaningful analysis will need to be based on performance over three, four or even five years.

Meaningful analysis also needs to;

  1. Measure and analyse a range of trends and ratios beyond what cash you have right now in the bank,

  2. Be a credible basis for forecasting business performance for the next few years,

  3. Help identify the areas of the business, whether its increasing sales or reducing expenses, that can be improved to increase profits and potential sale value.

If you do this analysis well there are 2 very big upsides;

  1. More money in your pocket from ongoing profits, and/or
  2. A higher price when selling.

So how do I start? 

And what will give me most bang for buck for my investment of time and money to do this meaningful analysis?

The straightforward process I’m going to outline now will get you started.

All you will need is the following;

  1. The last 4 years of tax returns

  2. Management accounts (e.g. MYOB or Xero) for the current incomplete financial year

  3. A spreadsheet (e.g. Excel)

  4. About 3 hours to input and formal all the information

Before getting underway I want to highlight something that is not universally understood by owners.

Net Profits in tax returns don’t usually or necessarily equal what the business earns for its owners.

The business profits declared in a tax return are often a long way from a true measure of underlying business profitability.

This happens because there are different ways to legally structure and finance a business, and legitimate ways to minimise tax.

A lot of owners only ever become aware of this when they start the process of preparing their business for sale and their business broker or adviser starts to make adjustments. These adjustments are used to explain the difference between the profits in the tax returns and the true underlying profit performance of the business for potential buyers. 

More on this later in the article.

After the business profits declared in tax returns are adjusted you can then come up with an estimate of Adjusted Maintainable Earnings.

Sometimes the estimate of adjusted maintainable earnings is based on an average of say three or four years. And where you have a new or fast growth business sometimes it is based on a credible forecast of future adjusted maintainable earnings.

Adjusted maintainable earnings, or similar terms, are commonly used by business brokers and business buyers in valuing the business for sale.

Rather than leaving this incredibly helpful analysis only when you think about selling, you should undertake it now. 

Then you can extract more profit from your business while you still own it.

Here’s how you do it.

Step 1.

Enter all the tax return profit and loss information directly from the tax returns onto one tab of a spreadsheet.

The information should look something like the below which isn’t very inviting or easy to read just yet.

A potentially tricky step is converting the incomplete current financial year into a projection for 12 months.

For this example I have taken the six months management accounts and doubled them for a simple full year projection.

It is essential that the bottom line net profit you calculate for each year is exactly the same as what is in the tax returns.

If this is the case then you are ready to take the next step in converting this information into some meaningful analysis.

Step 2.

Analyse financial performance with multiple years on a spreadsheet.

Now that you have four or five years of information on one page you can more easily see really important year to year trends including;

  1. Topline Revenue Growth,

  2. Gross Margin,

  3. Wages to Sales,

  4. Net Profit as a percentage of Sales.

With one more really powerful tweak though you make your analysis much, much more insightful.

The alphabetical chart of accounts.

All financial statements I have ever seen use a chart of accounts that runs in alphabetical order from a to z.

While it’s neat and orderly it isn’t particularly useful for analysis.

Smarter analysis of business performance.

Instead of listing the expenses from a to z they need to be re-ordered from highest to lowest. You do this by adding a new column which calculates the average expense over the number of years you have. You then sort all expenses from highest to lowest.

I haven’t in this simple example but you could include expenses for the current financial year based on the full year projection.

It should look like this.

When listed from highest to lowest the insights flow and obvious questions start to emerge.

  1. Given my major cost is for salaries (or wages) do I trim headcount or work on efficiency and engagement?

  2. Given there are categories of expenses that make up a very low percentage of sales will I get any ‘bang for buck’ by focusing on them

  3. If I need to grow sales by how much will I need to marketing expenditure and where should it be spent?

Add in a few basic formulas to the spreadsheet and you can calculate some ratios and trends. Then you are on your way to asking the tough questions and taking the right action.

Adjusting business financials to measure underlying profit performance and potential sale value.

There is a further step you can take to dig deeper on your financials. I mentioned earlier that this step is normally undertaken when a business is being prepared for sale.

It involves a process of ‘adjusting’ the financials so that;

  1. An adviser can value a business for sale, and/or

  2. A potential buyer can easily understand what level of profits they could expect to earn from the business. As I said earlier this is very often different from what the tax returns show as a bottom line net profit.

As it turns out there are often a large number of individual adjustments and in total they can;

  1. Make up a significant percentage of the ‘adjusted’ profit, and

  2. Significantly increase your potential business value in a sale

Certainly you should work through this step if you are thinking about selling, to give you a much better understanding of what your business might be worth.

But even if you aren’t thinking of selling this step is highly valuable as it forces you to think about effective ways to increase potential value.

Step 3.

Determining adjusted net profits to value a business for sale.

As you look at each expense item you need to think about the potential adjustments that I mentioned earlier.

This involves some science and some art.

But essentially you are trying to adjust the profit for items that can skew the reported net profit.

Here are four examples of typical adjustments used to establish adjusted maintainable earnings;

  1. Adjusting wages to ensure that it includes a commercial level wage for a working owner. Often what owners pay themselves is completely unrelated to the role they have in the business. The best way to approach this is to find from an employment site how much you would have to pay a new employee to do the role the owner does.

  2. Taking out any non-business expenses. For example sometimes the business will pay for personal cars or personal telephone expenses.

  3. Adjusting for discretionary expenses. For example the the existing owner might choose to attend an  international business conferences that is not critical to keep the business up to date.

  4. Adjusting for one off expenses. If an owner spent a lot of money in one year doing maintenance on equipment to extend its life by 10 years then its fair to add back some of that expense in the year it was incurred as it heavily impacts profit in that one year.

Working out legitimate addbacks to increase adjusted maintainable earnings.

The best way to approach the process of working out where the legitimate adjustments are is to go through the expenses from highest to lowest line by line and ask yourself this simple question.

Is that expense item a reasonable approximation of the typical annual cost to continue to run the business successfully?

To do this well it will help to do the following two things;

  1. Pretend you continue to own the business but you pay someone who is as competent as you to run the business so that you never have to work there

  2. Assume you want to maximise every last cent you could take out in profits.

When you have completed this step you are really well positioned to answer the ‘big questions.

  1. What are the smart ways to increase profitability?

  2. What are the most profitable parts of my business?

  3. What is my business worth to a buyer?

  4. How do I increase business value?

If you don’t get the answers you want then you may need help.

There a many, many way to approach improving the net profits and value of your business.

Maybe you need to outsource?

Maybe you need to upgrade your technology?

Maybe you need more staff?

Maybe you need to better understand the profit of your various products and services?

Our Business Owners Diagnostic is a pre-selling program designed to help owners answer these sorts of questions. Click here for more information on the program.

Until next time, Michael.

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