Businesses have a number of ways to measure their profitability and evaluate their financial strength. However, when a business is being sold, potential buyers are not primarily interested in its current net income. They want to measure its value as an acquired asset.
Adjusted net income is an indicator of how much a business would be worth to new owners after related expenses are factored in. While primary revenue can be assumed to remain stable as long as normal operations continue, several kinds of expenses and income streams shift when a business changes hands. Adjusted net income accounts for these factors in addition to the company's bottom line.
- Net income is a critical number for any ongoing business as it reflects all of the costs of doing business and all of the income it generates.
- Adjusted net income is critical for the prospective buyer of a business.
- Adjusted net income starts with the net income numbers that will stay the same under a new owner, and adds in estimates of costs that will be incurred by a change in ownership.
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.
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 might involve the salaries of the company's owners and management. Many business owners pay themselves below-market salaries to help the business along in the early stages. 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.
Other changes might reduce costs, such as combining overlapping functions between the company and its new owners.
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 into net income. In addition to the salaries of owners and management, this includes depreciation and amortization of assets, one-time payments made for costs ranging from equipment purchases to lawsuits, personal business expenses of the current owner, and rent if the property is not owned.
The net income of a business reflects all of the actual expenses and income generated for a given period of time. That's a critical number for a going concern but a prospective buyer has additional factors to consider.
Adjusted net income includes all of the costs and revenue sources that would stay the same under a new owner. However, it adds in the costs associated with transitioning the business to a new owner.
What Is Adjusted Net Income to Investors?
To investors and stock analysts, adjusted net income removes unusual or one-time expenses or transactions so that the core strength (or weakness) of the company can be seen. For example, a hotel company may sell an entire chain of hotels, booking a huge one-time profit. Or it may pay out a massive legal settlement, incurring a big one-time cost. Removing these from the picture allows the investor to evaluate the company's real long-term prospects.
What Is Adjusted Net Income to the IRS?
For tax purposes, adjusted net income is mostly relevant to non-profit entities that receive some business income. The vast majority of taxpayers are more familiar with adjusted gross income, which pops up on Form 1040. This is the same as gross income in most cases but can be lower for those who report alimony payments, educator expenses, or a few other upfront deductions.
Why Is Adjusted Net Income Important to Acquiring Companies?
Companies acquire other companies in order to increase their overall profits. That can backfire. One good way to make it backfire is to ignore the costs of transitioning a business to a new owner. Calculating adjusted net income is a way of anticipating the costs of the transition to evaluate whether it's worth it in the long run.
The Bottom Line
A company's net income is a good measure of its recent profitability, and a reasonable gauge of its long-term prospects. Or, it is if everything stays the same.
A bigger company that is considering acquiring that company will look at net income. Then, its managers will deduct the many costs associated with transitioning the business to its new owners. That is adjusted net income.