Understanding Cash Flow When Pricing Your Business

Honest, verifiable cash flow drives the sale price of a small business. Many buyers are first-time buyers coming out of corporate America, and their main goal is to replace the income from their former job. For these buyers, owner's cash flow is the main decision point on company value. A professional business broker can help you assess the details below and set an honest listing price for your business.

Owner's Cash Flow

Owner's cash flow is the amount of money a new owner could take out of the business each year. It is the net benefit to the owner, including perks and company paid expenses that benefit the owner. A business broker's job is not to create cash flow. It is to substantiate what the company financials, tax returns, and due diligence process document.

For example, if an owner made 100K in salary, the company made 50K in earnings, and the company paid 6K a year for a vehicle, 4K for meals and entertainment, 2K for a cell phone, and 10K for health insurance, the cash flow would be 162K a year. Each item has to be verifiable and listed on the tax return so the broker can justify adding back the expense as an owner benefit. The most common elements of cash flow follow.

Net Income

Net income before income taxes is what remains after all expenses are deducted from revenue. It is the amount federal taxes are based on. A good accountant keeps net income low for tax purposes, so a small net income does not give an accurate picture of the state of the business. For example, an owner might prepay expenses at the end of the year to push tax liability into the following year.

Owner Salary

Owner salary can be a large component of cash flow. Like net income, it can fluctuate for tax purposes. When an owner takes a salary, he pays taxes as both employer and employee, so he may take a smaller salary and pay himself through owner perks, known as add backs. For example, if an owner would need 6K more in salary to afford a Cadillac, he is better off having the business pay for the car and expensing it through the company instead of paying taxes on the extra 6K.

Depreciation and Amortization

Depreciation and amortization are components of cash flow. Both are non-cash expenses used to reduce taxes. Depreciation lowers taxable income but does not reduce cash, and lenders include both in their cash flow calculations. For example, if an owner depreciated real estate or equipment by 10K in a year, income drops by 10K and so does tax exposure.

Interest Expense

Interest is a component of cash flow because it relates to how a particular owner funded the business, not to the business itself. Interest can come from bank loans, personal loans, equipment leases, or any other debt instrument. If a new owner has enough capital and does not need financing, interest expense will not be a factor. For example, if an owner paid 5K a year in mortgage interest on the building and interest on equipment, that 5K is a direct write off and a cost of doing business.

Non-Recurring Expenses

One time or non-recurring expenses can be components of cash flow. Unless litigation happens every year, it is an example of an extraordinary, non-recurring expense. If an expense was non-recurring, the amount can be added back to cash flow. For example, we see owners get into a legal dispute or pay a one time professional fee, and we can add it back because it was a one off expense.

Owner Perks

One benefit of owning a small business is the ability to have the business pay for expenses that could be considered personal. The most common owner perks a buyer will accept include car payments, car insurance, health insurance, life insurance, 401K contributions, charitable contributions, IRA contributions, meals and entertainment, and travel and entertainment. If you have a paper trail for these add backs, a buyer and a bank will count them, and they will add to cash flow. For example:

• Net Income: $100,000
• Depreciation: $50,000
• Interest: $20,000
• Owner Salary: $80,000
• Owner Travel (Personal): $5,000
• Owner Auto (Personal): $6,000
• Owner Health Insurance: $7,000

Add the add backs and owner perks (company paid, owner benefited) and the number grows.

Owner's Cash Flow: $268,000

A word of caution about using owner perks to justify a selling price. If the buyer will finance the purchase or needs an SBA loan, the lender will make sure the add backs are real and can be sourced on the tax return. As the seller, you must provide tax returns, and the add backs will be sourced from the expenses shown on them. The result is called recasted cash flow: owner perks and add backs added to the salary and earnings of the owner and the business.

Without those items on the tax return, we cannot add them back to raise the value of the business. For example, if an owner spent 5K a year on meals and entertainment on his card, but the returns do not show it as meals and entertainment, we cannot source the add back and cannot add it to cash flow. It becomes a general expense that cannot be sourced. Banks are particular about what can and cannot be added back, and it depends on how the tax return shows each expense.

Thinking about selling? Start with the number. See what your business is worth.