Discretionary Earnings (DE), often referred to as Discretionary Income or Seller's Discretionary Earnings (SDE), and is a key metric used in business brokerage and valuation. It represents the total earnings of a business that are available to the owner before taxes and interest, and it accounts for various discretionary and non-recurring expenses. Here is a detailed explanation.
Definition of Discretionary Earnings
Discretionary Earnings is a measure of the total financial benefit that an owner can derive from a business. It includes the business's net income plus various adjustments for expenses and non-cash items that are considered discretionary or non-essential to the ongoing operation of the business.
Components of Discretionary Earnings
1. Net Income:
- Definition: The business’s profit after deducting all operating expenses, interest, taxes, and other expenses.
- Adjustment: Start with net income as the base figure for Discreationary Earnings.
2. Owner’s Salary and Benefits:
- Definition: The compensation that the business owner takes out of the business.
- Adjustment: Add back the owner’s salary, bonuses, and other benefits if they are above market rate or if they could be adjusted.
3. Non-Recurring Expenses:
- Definition: Expenses that are not expected to continue in the future, such as one-time legal fees, restructuring costs, or unusual repairs.
- Adjustment: Add back these costs to reflect the business’s ongoing profitability.
4. Non-Operating Expenses:
- Definition: Expenses not related to the core operations of the business, such as personal expenses of the owner.
- Adjustment: Add back any non-operating expenses that are not necessary for running the business.
5. Depreciation and Amortization:
- Definition: Non-cash expenses related to the wear and tear of assets and the amortization of intangible assets.
- Adjustment: Add back depreciation and amortization as they do not affect cash flow directly.
6. Interest Expense:
- Definition: Costs associated with interest payments on business loans.
- Adjustment: Add back interest expenses to reflect the business’s performance before financing costs.
7. Taxes:
- Definition: Business income taxes.
- Adjustment: Add back taxes since Discretionary Earnings focus on earnings before tax.
Calculating Discretionary Earnings
To calculate Discretionary Earnings, here are the steps:
1. Start with Net Income: Obtain the business’s net income from its financial statements.
2. Add Owner’s Compensation: Include the owner’s salary and benefits if they are above market norms.
3. Add Back Non-Recurring and Non-Operating Expenses: Include any one-time or unusual expenses.
4. Add Depreciation and Amortization: Include these non-cash expenses.
5. Add Back Interest Expense: If applicable, include the interest expense.
6. Add Back Taxes: If focusing on pre-tax earnings, include tax expenses.
Importance of Discretionary Earnings
- Valuation: Discretionary Earnings are commonly used in business valuation, particularly for small to mid-sized businesses. It provides a clearer picture of the business’s profitability and cash flow from a potential buyer's perspective.
- Buyer’s Perspective: For buyers, Discretionary Earnings, help assess the potential return on investment and understand the business’s financial health by considering what they could realistically expect to earn from the business.
- Financing: Lenders and investors often use Discretionary Earnings to gauge the business’s ability to service debt and generate sufficient cash flow.
Understanding and accurately calculating Discretionary Earnings is crucial for both sellers and buyers in the business brokerage process, as it reflects the true financial benefit of owning and operating the business.