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Understanding Owner’s Discretionary Cash Flow – MONEY TALKS AND B.S. WALKS

discretionary cash flow kansas city

Nothing is more important than honest and verifiable cash flow (Sellers Discretionary Earnings) on the sale price of a small business. Many buyers and business brokers go as far as stating that cash flow is everything. Over 75% of small business buyers are first time buyers coming out of corporate America. These people have one primary goal – to replace the income stream they lost coming out of their former jobs. For these buyers, the Seller’s discretionary earnings or cash flow of a small business acquisition is their salvation and their main reason for buying.

What is Sellers Discretionary Earnings or CASH FLOW? The simplest explanation is “The amount of money a new owner would be able to take out of the business annually.”

Through financial analysis, most of the components of Cash Flow are easy to explain, such as net profit and owner’s salary, while some of the figures may be somewhat more difficult to discern. A professional business broker can assist in recasting the business’ income statement to determine cash flow.

Net Income

Net Income before income taxes is the amount leftover in a business after all expenses are deducted from revenue. This is the amount on which federal taxes are based. The net income can fluctuate from more than the normal increases and decreases in revenues and expenses. A good accountant will attempt to keep net income as low as possible for tax purposes; therefore, a small net income does not reflect an unprofitable business.

Owner Salary

The amount of owner salary is normally a large component of SDE. Similar to net income, the amount of owner salary fluctuates for tax purposes. When a business owner receives a salary, he must pay taxes as an employer and employee; therefore, many times business owners elect to be paid a smaller salary and pay themselves through owner perks or net income.

Depreciation / Amortization

Depreciation and amortization is a component of CASH FLOW since they are both non-cash expenses that are used to reduce taxes. Depreciation decreases taxable income but does not reduce cash. Lending institutions include depreciation and amortization in their cash flow calculations.

Interest expense

Interest is a component of CASH FLOW since it is directly related to the amount of funding of an owner rather than the business. A new owner might have more capital and therefore not have the need for financing, subsequently reducing interest expenses to zero. Interest can be attributable to bank loans, personal loans, equipment leases, and other debt instruments that may go away after the sale.

Non-recurring expenses

One-time or non-recurring expenses can be considered components of CASH FLOW. In the most recently completed corporate tax year, if it can be determined that an expense in non-recurring or extraordinary, then the amount identified can be added to CASH FLOW. Extraordinary litigation expense is a good example unless litigation is an annual occurrence. Even uncollectible accounts receivable that are above the norm can most often be included. A company we worked with had annual average uncollectible for a five-year period of $10,000. A large customer went bankrupt, owing $130,000, which was written off as bad debt in the last corporate year. It was apparent that the amount over $ 10,000 would not be suffered in regular business operation; therefore $120,000 was added to CASH FLOW.

Owner perks

One of the most advantageous benefits of owning a small business is the ability to have a business pay for certain personal expenses. Owner perks consist of expenses that are personal to a specific owner; so none of these costs would be transferable to the new owner. If you have a paper trail of the owner perks, a buyer may then consider them in his analysis of sale price. We once sold a business that had 70% of the cash flow in owner perks. We would not have listed the business for sale had the owner not shown us a complete ledger, check register, and log of all his owner perks. The business sold to the second buyer to whom we showed the business and at full price.

The most common owner perks that are acceptable for a buyer are:

  • Car Payment
  • Spouse and children’s car payment
  • Car insurance
  • Spouse and children’s car insurance
  • Health Insurance
  • Spouse and children’s health insurance
  • Life Insurance
  • Spouse’s life insurance
  • 401(k) contributions
  • Charitable contributions
  • IRA
  • Meals and entertainment
  • Country club dues
  • Travel
  • Non-working family member pay

Below is an example of a calculation of CASH FLOW:

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
Owner’s Discretionary Cash Flow $268,000

Owner’s Discretionary Cash Flow

A word of caution in including owner perks in the cash flow to justify a sale price as the business will be financed through SBA or a conventional bank, institutions will vary as to what will be accepted as legitimate CASH FLOW. Business owners who LIVE OUT OF THEIR BUSINESS too much can see a lower sales price. It’s always safer to claim the income and pay the taxes to get the price you want for your business.

If you are looking to sell your business, contact Peterson Acquisitions for a free consultation.