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SDE measures how much you can make from operating a business. As a business owner it is important to be able to calculate business ratios and financial information, like Seller’s Discretionary Earnings (SDE). Knowing how to calculate SDE can help you predict how much money you’ll make from your business.
SDE can vary with many factors, including what industry you operate in. Keep in mind that SDE isn’t everything – a low SDE can be okay if a company takes little effort to run
How to Calculate SDE
Seller’s discretionary earnings is a calculation of how much money a business brings in for its owner. Another way to look at it is the amount you make pay yourself for running a company, though SDE assumes you don’t make discretionary purchases or investments in your company.
SDE is a popular way to value businesses. For example, someone looking to sell their company might price it based on a multiple of its SDE.
The formula to calculate SDE is:
(Net earnings before taxes + personal draw + non-essential expenses) – liabilities = SDE
Step One: Gather the Data Necessary for Business Valuation
Because SDE is commonly used to value a business, the first thing that you need to do is gather all of your company’s financial documents. That means gathering things like:
- Financial statements
- Tax filings and returns
- Business licenses, deeds, patents, and other documents
- A current balance sheet
Step Two: Determine the Business’s Net Earnings Before Taxes for the Year
Once you have all of your company’s information, you need to determine your company’s net earnings before taxes. Net earnings is the company’s revenue minus the expenses that your company paid, such as the cost of goods sold or purchases of new equipment.
Step Three: Add Owner’s Draw to Net Earnings
SDE looks at the total financial benefit that a business owner receives from a company, so you need to add the owner’s draws back to your company’s net earnings to find the SDE.
Owner’s draws are an expense for your company, but still put money into your pocket, meaning they’re a financial benefit for you that must be accounted for.
Step Four: Add the Sum of All Non-Essential Expenses to Net Earning Plus Owner’s Draw
You also need to add the sum of non-essential expenses back into net earnings. This includes things like travel, investments to grow the business, equipment repairs and upgrades, and similar costs.
In theory, you could forgo these costs and take more money out of the business and SDE looks at the maximum financial benefit you could receive, so these expenses are returned to net earnings to calculate SDE.
Obligatory expenses, like rent, wages, insurance, and cost of goods sold are not added back in because your company couldn’t earn money without paying these costs. For more information on company outlays see expenses of a small business.
Step Five: Tabulate All the Business’s Liabilities
Next, add up all of your business’s liabilities, such as debts, unpaid bills, and other expenses that you must pay.
Step Six: Deduct the Amount from Step Five (Liabilities) from the Total in Step Four (net earnings, owner’s draw, and non-essential expenses)
To find the overall SDE of your company, subtract the liabilities you calculated in step five of the calculation from the number determined during step four, which is the sum of your net earnings, owner’s draws, and nonessential expenses.
This result is the SDE of the company.
Sample Seller’s Discretionary Earnings (SDE) Calculation
Here’s an example of how to calculate SDE.
Your company produced a revenue of $500,000 last year with expenses of $350,000, putting its net earnings before taxes at $150,000.
During the year, you took an owner’s draw of $25,000. You also spent $10,000 on a new piece of equipment and $500 on travel expenses.
The company has $75,000 in debt that it is currently working on paying off and no other outstanding liabilities.
The SDE of your business is:
($150,000 + $25,000 + $10,500) - $75,000 = $110,500
Other Factors that Affect the SDE Calculation
There are many factors that influence SDE calculations. It’s important to understand how each impacts the end result.
When calculating SDE, you add back certain types of expenses to find the true financial benefit of owning the company. Some of the add backs include:
- Standard – some add backs, like personal expenses paid by your business and owner’s draws are standard across all businesses.
- Discretionary – Discretionary add backs include discretionary costs like above-market compensation and business entertainment.
- Non-recurring – Non-recurring add backs refer to one-time expenses, like investing in new equipment.
- Non-operating – Non-operating add backs are expenses that aren’t directly related to keeping your company operating.
- Accounting adjustments – Some accounting adjustments get added back when calculating SDE, such as non-operating income or below-market rent.
One of the most popular reasons to calculate SDE is to determine the value of a business so it can be sold. Depending on the industry of the business, different multipliers may be used to determine a fair value.
Other factors, such as the size of the business, market trends, and any tangible or intangible assets, such as goodwill or branding, may have can also influence the multiplier used to find a fair value for the company.
For example, if you have two companies, each with the same SDE but one with very strong branding and in an industry with growth potential, that company is likely worth more.
Why SDE is Important
SDE is important because it is one of the most popular ways to calculate the value of a small business. It indicates how profitable an enterprise is. However, it isn’t a perfect measurement.
Advantages of SDE
There are many benefits to calculating SDE.
- SDE is easy to calculate from some basic business information
- It’s used by many small business owners
- Standardized calculations help compare different businesses
Disadvantages of SDE
SDE isn’t perfect, so you need to be aware of its downsides.
- SDE ignores some things, like taxes, amortization, and depreciation
- Only useful for small businesses. Large companies usually use EBITDA.
- Some small businesses rely on the owner’s skills and reputation, which means they’ll be worth less if they change hands
While calculating your SDE you might also want to explore your small business cash flow management.
If you’re planning to sell your company, SDE is an important thing to calculate. Many people use SDE to determine the value of businesses, so knowing yours can help you price your company fairly and attract potential buyers and investors by saving them the effort of calculating it on their own.