Cash Flow 101
I’ve received a lot of questions recently as to what exactly the term “cash flow” means, why some expense items are included in its calculation, and finally what relevance it has on business transactions so I thought I’d provide some clarification.
Since most small businesses (those with earnings less than $1MM) are priced based on the amount of annual cash flow they produce, it is very important to understand exactly how this figure is determined.
Cash Flow differs from EBITDA slightly.
Simply put, Cash Flow includes all of the owner’s compensation wheras EBITDA simply normalizes the owner’s salary amount to that of what it would cost to replace the owner with a manager at current market rates.
The term “Cash Flow” is synonymous with “Seller’s Discretionary Earnings”, “Discretionary Earnings”, and “Owner’s Benefit” - they are all the same thing.
Cash Flow includes all income produced for the benefit of the owner before making any adjustments for income taxes, depreciation, interest expenses, amortization, the owner’s salary, and any personal “fringe” benefits to the owner that are not necessary to operate the business (i.e., personal vehicle not used in the business).
Why is Interest added back?
Since one business owner may utilize more debt to operate a company than another, all interest should be added back. Also, most businesses are transferred on a “free and clear” basis so a new owner will not incur any of the existing debt and related expenses.
Why is Depreciation added back?
Simply put, Depreciation is an accounting adjustment which is used to reduce the amount of taxable income. The business never actually “cuts a check” to pay for depreciation.
Why is Amortization added back?
Amortization is an accounting entry which is used to reduce the amount of taxable income by creating a deduction over a number of years (I.e., amount paid for goodwill when acquiring the business). Similar to depreciation, the business never actually “cuts a check” to pay for amortization.
What does this Cash Flow amount mean to me as a potential business buyer?
The cash flow amount shows how much income has been produced by the business annually. If the buyer pays all cash for the business then the cash flow amount can be used to estimate the amount of income the buyer should expect to earn as well as the return on their investment. If a buyer utilizes financing to acquire the business, the cash flow amount is important to determine how much money should be left over for them after paying the annual debt service (loan payments).