Financial statement recasting and add-backs, explained
Small-company books are kept to minimize taxes, not to show a buyer what the business earns. Recasting reverses that: it adjusts reported profit to the earnings a new owner would actually receive. Done well, it is the most valuable hour in the whole engagement. Done carelessly, it hands the other side their argument.
What recasting is
Recasting starts with pre-tax profit as reported and adjusts it, line by line, for items that will not continue under a new owner. The usual destination is seller's discretionary earnings — profit plus one working owner's total compensation, interest, depreciation, and the personal or one-time items. For larger companies with management in place, the destination is adjusted EBITDA instead, with owner pay normalized to a market wage rather than added back entirely.
The stakes are simple. Small businesses trade around 2.58 times SDE on average in reported transactions, so a $20,000 add-back moves value by roughly $50,000. That leverage cuts both ways, which is why every adjustment needs a basis you can point to.
Add-backs nobody argues with
Some categories are legitimate almost by definition, because they are structural rather than judgment calls:
- One owner's compensation and payroll taxes. SDE is defined as earnings available to a single working owner, so the seller's salary, bonus, and the employer taxes on them come back.
- Interest expense. The buyer brings their own capital structure. The seller's debt service is irrelevant to earning power.
- Depreciation and amortization. Non-cash charges come back, though a capital-hungry business earns a note about ongoing equipment spending — the buyer will make one.
- Clearly personal expenses. The owner's health insurance, personal vehicle, country club dues, the family cell phone plan. If it would vanish the day the owner leaves, it comes back.
Add-backs that get challenged
A second group is defensible sometimes, and every experienced buyer, lender, and opposing expert goes straight to it:
- Family members on payroll. Legitimate only to the extent their pay exceeds what a replacement would cost. If a spouse earning $60,000 does bookkeeping a $45,000 hire could do, the add-back is $15,000, not $60,000. And if the family member works for free, an adjustment runs the other direction.
- "One-time" expenses that recur. A lawsuit settlement is one-time. Repairs, bad debts, and recruiting fees that appear in some form every year are operating costs wearing a costume.
- Rent adjustments on owner-held real estate. Adjusting rent to market is correct. Adjusting it to a number that flatters the earnings is common enough that any rent add-back should cite an actual market comp for the space.
- Second and third owners. SDE accommodates one working owner. If two owners each draw pay and both work full-time, the second owner's role must be replaced at market cost before their compensation is added back.
- Cash the books never saw. Unreported revenue cannot be added back. There is no documentation for it by construction, and claiming it undermines every number in the file.
A useful test
For each proposed add-back, ask: would a rational buyer, running this business with a market-wage manager, avoid this expense entirely? If the honest answer is "partly," add back the part, and write down how you split it.
Documenting the basis
An add-back schedule that says "auto expense, $14,200" is an invitation to a fight. One that says "auto expense $14,200, owner's personal vehicle, per GL account 6120 and the loan statement in exhibit C" ends the fight before it starts. For each adjustment, record three things: the amount, the source document, and the reasoning in one sentence. Tie every figure to the general ledger or tax return line it came from.
Consistency across years matters as much as support within one. If travel is added back in 2023 but not 2024, be ready to say why. A recasting schedule covering three to five years, with the same categories handled the same way in each, is what turns "the seller says it earns more" into an earnings history a lender will underwrite. In ExitSight the recasting worksheet holds the note behind each add-back, and the schedule prints in the report with the reasoning attached.
Continue withthe whole valuation process, see how recast earnings drive themultiple of discretionary earnings method, or read aboutcapitalized earnings for companies where owner pay is already at market.