Buyers don't look at the profit shown on the books. They look at the cash the business actually generates, year after year, once it's been kept in shape. Three things interest them above all: how much money is really left over, how genuine the profit is after personal entanglements are removed, and how consistent it is from year to year.
Warren Buffett, in his letters to shareholders, uses a concept that serves every small business: owner's earnings. The idea is simple. Accounting profit isn't the cash you can take home, because the business has to take care of itself. The van wears out, equipment needs replacing, the premises will need refreshing. Owner's earnings are net profit plus depreciation, minus the investments required just to keep the business where it is. This is the number a smart buyer always calculates, even when you don't show it to them. And it's the number you yourself need to know, because it's what supports your dividends and plans, not the paper profit.
The second number the buyer asks for is normalized earnings. Small business statements often contain two types of distortions that point in opposite directions. On one hand, the owner's personal expenses reduce apparent earnings. On the other hand, the owner's unpaid labor inflates profit, because the buyer will have to pay a manager in your place. Normalization removes both. Personal expenses are excluded and profit increases. A market wage for your work is brought in and the profit drops. What remains is the true profit of the business as a business. This exercise is best done two or three years before any sale discussion, so that the history of the numbers is clean.
A small construction company in Tirana reports a net profit of 4,000,000 LEK. The economist calculates the owner's earnings. Net profit of 4,000,000 LEK plus depreciation of 700,000 LEK minus necessary investments for replacing tools and the van, averaging 900,000 LEK per year. That leaves 3,800,000 LEK in real cash. Then she performs the normalization. The owner works as a technical manager without pay, whereas such a manager on the market costs 1,800,000 LEK per year. On the other hand, 400,000 LEK in personal expenses pass through the company and are deducted. The normalized cash profit comes out as 3,800,000 minus 1,800,000 plus 400,000, so 2,400,000 LEK. This is the number on which a serious buyer builds their price. Not 4,000,000. Whoever knows this number before the buyer is negotiating from a strong position.
In the Resource Center, find the Statement of Income. Enter net income, depreciation, holding investments, and normalization adjustments, and the sheet will produce owner's earnings and normalized income for the past three years. You'll find it under… Resource Center.
The bridge from accounting profit to owner's earnings is built in four documentable steps. Net income from the statements, plus depreciation and amortization, minus sustaining investments, excluding growth investments, plus or minus the change in working capital requirements as the business grows. The distinction between maintenance investment and growth investment is the most delicate judgment in the exercise and is documented in the asset register and their ages. The multiple is then applied to the normalized profit. International practice uses multiples by sector, with recurring-revenue services commanding higher multiples than trade or one-off project construction, and size, owner dependence, and customer concentration shift them within the sector range. Specific multiple figures cannot be given responsibly without reviewing the sector, the size, and the quality of the business's data, so any serious valuation starts from documented normalized earnings, not from a barroom multiple.
Because the accounting profit includes depreciation, personal allowances, and your forgone salary. The buyer strips all of these out and calculates the real cash. If you do this calculation first, you know your value before anyone else tells you.
Yes, because the owner's earnings also serve as the healthy limit on your withdrawals. Anyone who withdraws more than the money the business actually generates is feeding their lifestyle by eating into the business. These metrics protect you from this silent mistake.
If you want to calculate your business's owner's earnings using real figures, a conversation with our economist is all it takes to get started. Find us at Contact page.
We take care of accounting and taxes, so you can save time, money, and focus on growing your business.
Request a Quote
