Specialists use different measurement methods of the company’s overall financial performance. If you are going to buy a business, you need to know how to use at least several of them.
In the case of a small or middle-size company, such a measure as seller’s discretionary earnings is the most appropriate one to find out the business's growth potential and market value. In this article, we will talk about:
- The meaning of SDE;
- The difference between EBITDA and SDE;
- Why it is so important to understand the SDE basics;
- The components of SDE;
- How to value a small business with the help of SDE.
What is SDE?
Seller’s discretionary earnings or SDE is a measure of business earnings. The users use this metric to measure the value of the business to find out the expected return of investment. As for the sellers, SDE helps to maximize the value before negotiating with buyers. Also, it is useful for choosing what incomes and expenses to include.
Seller’s discretionary earnings involve several components:
- Pre-tax profits before non-cash expenses;
- One-time expenses;
- Non-related business expenses/income;
- Adjusted expenses.
Why SDE is Important
There are many other ways to measure a business, but the seller’s discretionary earnings are the best because they implement a multiple to the business value.
Even if the companies are related to the same industry and have the same size, each has a unique set of books. Thus, it is impossible to succeed in the market without comparing the value to similar businesses. And the SDE is the appropriate tool for this goal.
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If you are an owner of a small business, it is crucial to understand SDE and how it is calculated. It will provide a better vision of business earnings and how to increase its value. Furthermore, SDE is necessary to develop a working business strategy.
Components of SDE
Here, we will talk a little bit more about the components of SDE. When the owner wants to sell the business, it is crucial to consider various types of income and expenses. Therefore, different components in the calculations will be helpful for both parties during the negotiation.
Profits Before Non-Cash Expenses
Pretax and pre-interest profits involve earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). It is necessary to find out the earnings of the company. With these calculations, the investors can measure the amount of the returned investments.
This component of the SDE includes the non-recurring expenses. For instance, the one-time expenses can refer to purchasing a business license, legal fees, and the budget spent on website design services.
Adjusted expenses are those that are complimentary for the valued business. For example, if the company sells books, the buyers should know how much money the owner spent on the storage rent, transportation, and so on. The matter is that these expenses affect the success of the business and show the amount of budget necessary to include in the overall budget.
Non-Related Business Expenses
Finally, the non-related business expenses and incomes are the amount of money earned/spent on services that don’t refer to the core business operations. For example, it can be a sum of money spent on consulting services or office rent.
How to Value a Small Business
The public companies are usually valued as a multiple, including such things;
- Earnings before interests (EBI);
- Taxes (T);
- Depreciation (D);
- Amortization (A).
But the small and middle-size businesses use another scheme, which is SDE. It is a little more complex because SDE calculations include additional expenses mentioned above. However, knowing the budget spent on different expenses out of the list of traditional EBITDA models makes it easier to understand the company's potential.
Apart from net income, the seller’s discretionary earnings consider such spendings:
- The total salary of the owners;
- Perks received by the owners (e.g., personal travel spendings);
- Leisure activities;
- Any personal expenses noted as expenses on the business tax returns;
- Business travels that can be regarded as non-essential for running the company;
- Charitable donations;
- One-time and non-cash expenses.
Difference between EBITDA and SDE
As is mentioned above, SDE is much more complex and larger than EBITDA. One more important factor to mention is that EBITDA calculations are necessary to compare the business to other companies in similar industries. But when talking about the SDE, it has a wide range of benefits, including the ability to find out the business potential for growth.
There are also several fundamental differences between SDE and EBITDA, including:
- SDE includes the owner’s salary and a number of add-back expenses;
- SDE helps the potential buyers to find out how much money is possible to get after the investment;
- EBITDA is used mainly for comparison of the companies;
- SDE is used to calculate the value of the businesses with a profit of less than $5 million;
- It is better to apply EBITDA to measure the value of big corporations.
With an understanding of these measurement tools, the buyer can get a clear vision of the business potential. By the way, both EBITDA and SDE are also helpful for the owners because regular calculations are necessary to analyze the expenses and incomes. According to this data, it will be easy to develop a working business strategy.
To conclude, understanding such a concept as SDE is essential for both business owners and potential buyers. SDE calculations will be especially helpful during the negotiation, as it measures the company’s potential.
Compared to other measuring methods, SDE is more complex because it includes diverse components. So, it will help to get a clear vision of all business processes (both core and extra) that affect the potential growth of the small business.
Author's Bio: Ian Rushton is a specialist in Marketing and Business Consulting. He has worked as a business consultant for over 10 years. Ian is also a blog author on PaperWriter sharing his experience in Business Studies and Finance. He has several publications in the field of Marketing, Finance, and Accounting.