Metrics that reflect profitability at various stages are generally used to evaluate the relative financial strength of a company. However, when a business is being sold, potential buyers determine its value as an acquired asset rather than simply looking at its net income.
Adjusted net income is an indicator of how much a business would be worth to new owners. While primary revenue can be assumed to remain stable as long as normal operations remain stable, several kinds of expenses and income streams shift when a business changes hands. Adjusted net income accounts for these factors in addition to a company’s bottom line.
Determining Adjusted Net Income
The calculation of adjusted net income begins, as its name implies, with net income. Net income is the sum total of all revenue, expenses, debts, taxes, interest and additional income for a given period. Like other accounting measures, it is susceptible to manipulation through such things as aggressive revenue recognition or by hiding expenses. Net income is the most comprehensive metric of profitability for a company’s operations. However, under new ownership, those operations might change.
One major change may involve the salaries of the company’s current owners and management. Many business owners pay themselves below-market salaries to help the business along in early stages, or they collect the difference in dividends at the end of the fiscal year. If a new owner hires someone to run the business at the market rate, a certain amount of revenue is needed to cover this salary increase.
Potential buyers need to know how much capital they have to work with to cover all the changes they would implement as new owners.
To estimate the value of a company in this context, various expenses are added back in to the net income. In addition to the salaries of owners and management, this includes depreciation and amortization of assets, one-time payments made for events such as lawsuits or equipment purchases, personal business expenses of the current owner and rent if the property is not owned.
Net income accounts for all actual expenses and income generated for a given period, while adjusted net income reflects only those figures that would not change under new ownership.