What is the least intuitive feature of the pricing model?

Probably the least intuitive feature of the pricing model, and one of the most useful, is the fact that on the Step 4 income statements Total Expense is a required input. Intuitively one would expect that total expense would be calculated. In the pricing model it is a required input. Other Expense, which is normally a user input, is a calculated value in the pricing model. The pricing model was programmed this way, as described in Step 4 of this User’s manual, to allow the user to create a quick and dirty pricing calculation without entering every expense on the subject’s income statement. The user can enter as many, or as few, individual expenses as desired. Other Expense is then calculated as the difference between Total Expense and the sum of the individual expense entered. If all individual expenses are accurately entered for a pricing report that will be provided to a client, Other Expense will be zero.

What does it mean when I can’t select some of the steps from the “Step” drop-down list?

In general, if the steps are disabled and grayed out they cannot be selected. If the Market Method of Step 8 or any other step is “grayed out” on the “Step” drop-down list, it means that you have not entered all of the required data on the previous step. For the Market Method of Step 8, this usually means that the “Period Ending” date has not been entered on the Balance Sheet of Step 7.

Note: Internet Explorer 7 may allow the User to select the disabled steps. However, if you click on a disabled step, the program will take you back to the step you were on prior to clicking on the disabled step. The easiest way to avoid any confusion related to Internet Explorer 7 is to download Internet Explorer 8 from the Microsoft website at (www.microsoft.com/windows/internet-explorer/default.aspx).

I entered all the data and saved it per the instructions but the calculated SDE value doesn’t make any sense. What’s wrong?

This usually means that you have not entered Total Expenses in the Statement column. As noted at the top of the Step 4 screen, Total Expense is a required input and Other Expenses is calculated.

When I delete an expense account name that I previously entered, most of the data I entered disappears, why does this happen?

Prior to deleting any user defined account names, click on Calculate/Save at the bottom of the screen. If you neglect to do so, any data you have entered since your last save will be deleted.

How many months of income statement data is needed to get accurate results when annualizing?

In general, the more months the better! However, even if you are annualizing an income statement for a nine or ten month period the results can still contain significant errors.

There are many ways that errors can be introduced into annualized income statements. Each of these errors can significantly impact the subject’s pre-tax net income and SDE. Always review the annualized statement with the client to ensure that the annualized revenue, cost of goods sold and general & administrative expenses are reasonable. Some of the most obvious problem areas are listed below:

a. Un-deposited cash from prior year
b. Prepayment of Expenses at the end of a year
c. Understated Inventory – Increases Cost of Goods Sold
d. Annual payments made in the first part of the year
e. Payments, or expense adjustments, normally only made in the second half of the year or at year-end

Items a. through c. may be a wash after the end of the fiscal year if the owner does the same thing each year. For example, if the business has cash basis financial statements and the owner holds un-deposited cash of around $100,000 at every year-end that is deposited in the following year, it would be a wash after the fiscal year is closed out. However, at the beginning of the year the subject’s revenue and profit are over-stated by $100,000. If six month financial statements are annualized, the revenue and net profit will be over-stated by $200,000.

If the amount of un-deposited cash varies from year-to-year, it won’t be a wash at the end of the year. For example, if the subject purchased some new asset at the end of 2008 with the result that there was no un-deposited cash for the first time in many years, but the business had un-deposited cash of $100,000 at the end of 2009, the year end revenue and profit for 2009 would be overstated by $100,000. However, interim statements for 2009 would be accurate, i.e., they would not be overstated due to un-deposited cash.

Do I have to normalize income statements in every year for which I enter data in the pricing report?

Yes! For consistency you want to show the subject’s financial performance as it would be with income and expenses normalized. In addition, if you only make adjustments in the most recent year and then weight more than one year to determine the average weighted SDE, you are combining apples and oranges (i.e., adjusted and unadjusted income statements).

Should I add back all depreciation or just some of it?

The answer to this question can vary from business to business depending on the how asset intensive the business is, and how often the subject’s assets have to be replaced. In general, add back all depreciation since SDE is defined as earnings before owner compensation, amortization/depreciation, interest and taxes.

However, if the subject is a business with relatively high annual capital expense you need to compare annual capital expense (capex) with annual depreciation expense and make the appropriate adjustments. If they are roughly equal, maybe you don’t add back any depreciation. If you handle annual capex in this manner, adjust the annual capex expense in the Buyer’s Test so you aren’t double-counting it.

If there are two owners that will be leaving the business, do you add back both salaries?

SDE is defined as having one owner’s salary added back. There are two ways to deal with multiple owners (two owners in this example) and they both give the same answer:

a. Add back the salary of the principal owner and make an adjustment for the difference between the second owner’s compensation and what the new owner will have to pay a qualified employee(s) to replace the second owner, or,

b. Add back salaries of both owners (positive add-backs), and, add the expense (negative add-back) of replacing the second owner with a qualified employee(s)