Recasting Financial Statements: How Sellers Normalize Earnings and How Buyers Verify Them
Recasting is the process of taking a business's reported financial statements — which are typically optimized to minimize taxes — and adjusting them to show what the business actually earns in cash flow available to a new owner. The result is a recast or normalized P&L, and it's the foundation for any serious valuation conversation.
Small business owners have every incentive to minimize reported income: it reduces taxes. But it also makes their business look less profitable than it truly is. Recasting reverses those minimizations so the buyer can see the real picture.
The Recasting Process
A recast starts with net income on the tax return or P&L, then works line by line through every expense, asking: "Would a new owner have this expense?" If yes, it stays. If no — because it's personal, non-recurring, or non-cash — it's added back.
Step 1: Start With Reported Net Income
From the federal tax return (Schedule C, Form 1065, or Form 1120-S depending on entity type). This is the verified baseline.
Step 2: Add Back Owner Compensation
The owner's salary, payroll taxes, health insurance, retirement contributions — all add back to the pool. The new owner will pay themselves from this same pool.
Step 3: Add Back Non-Cash Charges
Depreciation and amortization don't represent actual cash leaving the business — they're accounting entries. Add them back.
Step 4: Add Back Non-Recurring Items
One-time legal fees, equipment repairs, moving expenses, startup costs for a product line that was abandoned — any expense that won't recur gets added back. This is where scrutiny is most needed (see add-backs).
Step 5: Add Back Personal Expenses Run Through the Business
Personal cell phones, personal vehicle expenses, personal travel, family member salaries above market — common adjustments in owner-operated businesses.
Step 6: Normalize Anomalies
A year with unusually low revenue because the owner was ill. A year with unusually high costs because of a one-time expansion. These may be normalized or excluded from the trailing average.
The Output: SDE or Adjusted EBITDA
The result of recasting is typically presented as Seller's Discretionary Earnings (SDE) for businesses under $2M in earnings, or adjusted EBITDA for larger businesses. SDE includes the owner's total compensation in the add-back; EBITDA excludes it (assuming a hired manager instead).
Example: A Recast in Numbers
| Line item | Amount |
|---|---|
| Net income (tax return) | $85,000 |
| + Owner salary | $70,000 |
| + Owner health insurance | $12,000 |
| + Depreciation | $18,000 |
| + Owner vehicle | $9,000 |
| + One-time legal settlement | $25,000 |
| = SDE (recast) | $219,000 |
A business that looks like it makes $85K on paper actually generates $219K in owner benefit — a 2.6× difference. At a 3× SDE multiple, the difference between using reported net income vs. recast SDE is $402,000 in purchase price.
How Buyers Verify a Recast
Every add-back should be traceable to a bank statement, receipt, or payroll record. Request the source documents for any add-back over $10,000. Reconcile the recast P&L against the tax return line by line — any significant gap that can't be explained is a red flag. The definitive verification check: do bank deposits for the period match reported revenue?
Related Terms
- Add-backs — the individual adjustments that make up the recast
- SDE — the metric produced by recasting for owner-operated businesses
- Due diligence — where the recast is verified