What is an addback?
I have to admit, when I first heard this term, I had a picture of a redback spider in my head. Needless to say, I wasn’t too fond of the word at first.
But once I got my head around it, boy did it open my eyes. It’s an essential part of understanding the true profitability of a business.
… so what is an addback?
An addback is an unusual or non-business expense that is taken out of the profit & loss statement. This lifts up the business’ net profit to its true operational profitability for prospective business buyers.
But should we be fudging the financial statements?
As part of an accountant’s job to help businesses minimise their taxes, they can apply expenses like interest on a business loan to their business. This reduces the net profit of the business, which in turn reduces the tax the owner has to pay on their income.
Another example is depreciation. Like the above, depreciation can be claimed as an expense, which reduces the net profit of the business (and thus the tax the owner has to pay).
So what’s the significance? Depreciation and interest on a business loan do not affect the actual running of the business, and so shouldn’t be used to determine the true profitability of the business.
OK, so why is it called an ADDback? Isn’t it about taking out expenses?
OK, this part gets a little into accounting-speak, so if you don’t understand what I mean, let me know below and I’ll explain.
This is what a typical P&L (profit & loss statement) looks like.
| Sales | $a |
| – COGS | $b |
| Gross Profit ($a – $b) = | $c |
| – Expenses | $d |
| Net Profit ($c – $d) = | $e |
Now, that’s all fine and good, but when you want to lift the profitability of a business to its maintainable net profit (i.e. with addbacks included), you include what’s called an addback schedule.
The addback schedule contains a list of addbacks to ADD back onto the net profit. What it essentially does is reverse those expense items so you get a better appreciation of the maintainable net profit of the business.
So it looks like this now:
| Sales | $a |
| – COGS | $b |
| Gross Profit ($a – $b) = | $c |
| – Expenses | $d |
| Net Profit ($c – $d) = | $e |
| + Addbacks | $f |
| Maintainable Net Profit ($e + $f) = | $g |
Hope that explains it. If you don’t get it, leave a comment below and I’ll get back to you.
Otherwise, if you have any other questions about buying or selling a business, please let me know in the comments.
Chris Khoo
Business Broker
Related posts: