Seller Discretionary Earnings (SDE) Is The Key To Increasing The Value Of A Business

Many buyers will consider SDE when looking to buy a business as a common way to compare the value of two companies

Profitability is a key measurement of success, and there are several ways to determine whether or not a business is meeting planned goals. Seller Discretionary Earnings (SDE) is a primary profit measurement for small businesses — yet many owners overlook the key metric.


SDE refers to the total financial benefit that a single, full-time business owner gains from a business on an annual basis. Also known as adjusted cash flow or recast earnings, SDE is the most common measure of cash flow that highlights the value of a small business.


As a common way to compare the value of two companies, many buyers will consider SDE when looking to buy a business. So, what does SDE mean and why should small business owners focus on this metric?

The Main Purpose of an SDE


SDE is a common valuation metric for small businesses and lays the foundation for other valuation metrics.  Most small business buyers and many lending institutions use SDE to make purchase and financial decisions. 


Understanding SDE


SDE allows interested buyers to compare two businesses, providing common ground for assessment regardless of industry. It also offers a rough estimate of cash flow that can be used to pay back interest, cover debt or invest in necessary equipment after acquisition.


It’s important to note that SDE is not a measurement of profit and loss. Nor does SDE refer to the income that is reported during tax season. Instead, the term refers to the total benefit received by the owner of the company, regardless of how the finances are later utilized.


Buyers looking to purchase a business look at SDE to get an indication of the current earnings (and potential growth) of businesses on the market. Serving more than a single purpose, SDE can be used as an income-based and market-based valuation method.


SDE Calculation


There is a fairly straightforward calculation to use SDE as a valuation metric and typically involves the following considerations.


●     Pre-tax net income

●     Owner’s compensation

●     Interest

●     Depreciation

●     Amortization

●     Discretionary expenses

●     Non-operating and non-recurring expenses


Benefits of a SDE Calculation


As an introduction to the value of a business, there are several reasons small businesses should focus on a SDE calculation.

Consider the following benefits of SDE.


●     A commonly used method that is widely understood (and accepted) by buyers, sellers, and brokers

●     Simple to calculate with a reduced risk of error, allowing for convenient comparisons

●     Removes non-operating variables and non-cash expenses that will be irrelevant after an acquisition is made


While SDE is considered a rule of thumb for valuation measurement, a deeper dive into business financials is needed for enhanced accuracy.


How to Manage an SDE


As a small business owner wanting to sell, you need to consider your SDE and how it compares to other businesses. Responsibility for the discretionary cash flow falls on the shoulders of management.


As your SDE increases, so does the value of your business. As a business owner, there are two main ways to increase SDE.


Increase Sales


It may seem obvious, but one of the most effective ways to increase SDE is by boosting the bottom line. Increasing sales or prices directly reflect in an increase in SDE. 


Another way to increase sales involves creating (and selling) new products and services that meet demand. If you choose this option, then make sure to pursue low-risk ventures to avoid the loss of cash flow.


Decrease Expenses


Decreasing expenses can increase your profit margin and has a direct impact on the SDE. Some of the most effective ways to lower financial expenditures include insurance policies, avoiding unnecessary debt, downsizing office space, and automating processes.


While decreasing expenses is a low-risk strategy for increasing SDE, it can be difficult if there aren’t any notable expenses to cut back.


An Accurate Representation of Your Business Value


If you can afford to sell your business and looking to put it on the market, then you need to make sure that your financials are presentable.


SDE is a measurement that will be considered along with other factors such as customer concentration, employee skill level, growth rates, systems, working capital requirements, and more. Even with SDE being used as an introductory measurement, additional methods should be focused on for the accuracy of valuation and an expert broker can help with the process.

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