Discretionary Owner Earnings: What It Is and Why Bankers Use It

Getting ready to apply for a commercial loan, but not sure if your financials will receive an approval from the bank? This is part of a series of posts explaining financial equations and ratios so that you feel more prepared when you talk to the bank about your loan request. Next up: Discretionary Owner Earnings.

What Are Discretionary Owner Earnings?

Discretionary Owner Earnings measure how much income a business can generate for its owner(s). This formula factors in not only the actual compensation received by the business owners, but also its Pre-Tax Net Income and non-cash expenses like Depreciation. Discretionary Owner Earnings can also include expenses like auto expenses, professional fees, and rent/maintenance costs, depending on the business. It's a subjective measure tailored to each business. Here's how you can calculate it:

Why Is It Important?

Discretionary Owner Earnings is important from both the banker's perspective and for individuals looking to purchase an existing business. Bankers look to Discretionary Owner Earnings to determine if the income available to a business owner is enough to cover their personal debt payments and allow them to maintain or improve their quality of life. For an individual interested in acquiring an existing business, Discretionary Owner Earnings shows how much income they can receive from the business assuming they operate at the same efficiency. It also gives a prospective buyer an indication for how long they need to operate the business in order to make a return on investment.

Example of Discretionary Owner Earnings

Jane Doe, sole owner of ABC Company, pays herself $75,000 in officer compensation, shows $10,000 in depreciation expense on her taxes, and has pre-tax net income of $15,000. Jane Doe's Discretionary Owner Earnings would be:

In this same example, let's assume that ABC Company shows rent expense on its books of $50,000, but Jane also owns the building that ABC Company operates from. Discretionary Owner Earnings would increase to $150,000 because Jane is directly benefiting from the rent that ABC Company pays.