Understanding Cash Flow in a Business When Determining Selling Price

Understanding Cash Flow When Selling a BusinessHonest and verifiable cash flow will greatly impact the sale price of a small business. Many small business buyers are first-time buyers coming out of corporate America. Their primary goal is to replace the income stream from their job (or former job). For these buyers, the owner’s cash flow represents their main decision point regarding company value. A professional business broker can help you assess the following details and present an honest listing price for your business.

Owners Cash Flow

What is Owners Cash Flow? The simplest definition is that it is the amount of money a new owner would be able to take out of a business annually, or 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, but to be able to substantiate what is documented through company financials, tax returns, and a due diligence process.

For Example – If a business owner made 100K in salary, the company made 50K in earnings, and the company paid for a vehicle at 6k a year, and meals and entertainment of 4K a year, and cell phone of 2K a year, and health insurance of 10K a year—the Cash Flow would be 162K a year. Of course this has to be verifiable on the tax return and be listed on the return so the business broker can justify “adding back” the expense as an owner benefit. The following are the most common elements that comprise cash flow.

Net Income

Net income before income taxes is the amount remaining after all expenses have been deducted from revenue; it is the amount on which federal taxes are based. A good accountant will keep net income as low as possible for tax purposes- therefore, a small net income does not necessarily reflect a completely accurate picture of the state of the business.

For Example – a business owner might prepay expenses toward the end of the year in order to push tax liabilities to the following year.

Owner Salary

The amount of salary paid to the owner can be a large component of cash flow. Like net income, the amount of owner’s salary can fluctuate for tax purposes. When a business owner receives a salary, he has to pay taxes as both an employer and employee, so the owner may elect to take a smaller salary and pay himself through owner perks or what will be called “add backs”

For Example – If a business owner paid himself 6K more than he is paid now to afford a Cadillac, he is better off having the business pay for it so he doesn’t have to pay taxes on the 6K, rather expense the car through the company and avoid taxation.

Depreciation/Amortization

Depreciation and amortization are components of cash flow. Both are non-cash expenses used to reduce taxes. Depreciation decreases taxable income but does not reduce cash. Lending institutions include depreciation and amortization in their cash flow calculations.

For example – If a business owner depreciated his real estate or his equipment 10K in a year, it would reduce the income by 10K therefore reducing tax exposure.

Interest Expense

Interest is a component of cash flow since it directly relates to the amount of funding of a particular owner rather than the business. Interest can be attributable to bank loans, personal loans, equipment leases or any other debt instrument. If a new owner has sufficient capital and does not need financing, interest expenses will not be a factor.

For example – Mortgage interest on the building and interest on the equipment is a direct cost of doing business. If a business owner paid 5K a year in interest, it is a direct write off. A cost of doing business.

Non-recurring expenses

One time or non-recurring expenses can be components of cash flow. Unless litigation is a common annual occurrence, it is an example of extraordinary, non-recurring expense. If an expense was non-recurring the amount can be added back to cash flow.

For example – sometimes we see business owners get into a law dispute, or a one time professional fee. We can add this back because it was a rare-one off expense.

Owner Perks

One of the benefits of owning a small business is the ability to have a business pay for certain expenses that may otherwise be considered personal. The most common owner perks that are acceptable by a prospective buyer include car payments, car insurance, health insurance, life insurance, 401K contributions, charitable contributions, IRA, meals and entertainment, and travel and entertainment.
If you have a paper trail for these benefits or add backs, a buyer and a bank will consider them as such and it will add to the 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 $7000

Once you add the various add backs or owner perks (company paid but owner benefited) you end up with a much higher number-

Owners Cash Flow- $268,000

A word of caution about including owner perks in the cash flow analysis to justify a selling price should be noted. IF the business will be financed or an SBA loan will be needed to purchase the business, a financial institution will in fact make sure that the add backs are real and able to be sourced on the tax return. You, as a business seller, must provide tax returns and the add backs will be sourced from the expenses shown on the return in order to add them back or show them as income or benefit to the owner.

The term used is “Recasted Cash Flow”, which is the add back or owner perks added to the salary and earnings by both the owner and the business. Without showing them on the tax return, we will not be able to add them back to get a higher value of the business.

For example – If an owner spent 5K a year in meals and entertainment on his card, but it is not shown on the returns as meals and entertainment, we cannot source the add back and therefore cannot add it to the income or cash flow. It would be a general expense, in which case it is not able to be sourced and added back as such. Banks are very particular on what can and can’t be added back depending on the tax return and how it shows the expenses.

Hopefully, this all makes sense to you. If not, we are here to help you navigate through it all. Call us if you have questions or download more helpful information below that will help increase your selling price.