Sam Durso’s Blog

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).

Just like the real estate market has changed significantly over the past 3 years, so has the business acquisition outlook. Unfortunately the poor economy, the lack of bank financing, and the shrinking number of willing and able buyers have all led to an extremely difficult time to sell a business. Values have been severely affected and very few deals have made it to the closing table over the past 18 months.

Let’s face it; buyers are extremely cautious right now as to where the world is going. They have witnessed some of the country’s largest businesses being completely wiped out. They have seen many small businesses struggling to survive in the current economy and there have been very few signs to give them optimism about the near future.

Most business buyers in today’s market are LOOKING at a lot of businesses but are simply not pulling the trigger when it comes time to actually part with their money.

So what now???

Well, that depends. For those business owners who absolutely need to sell in the short term, you should focus on positioning your business properly so that buyers will be able to see the future viability of the business as well as all of its positive aspects. You will need to price your business in line with its current financial performance. It’s amazing how many businesses are currently being marketed for sale at an asking price that is based on sales & profit data from three years ago even though many of these companies have seen their sales & profits decrease by over 50%!

For those business owners who would like to sell but are in a situation where they can be a bit more patient the answer is simple. Wait!

Instead, now can be a great time to take a close look at your company and focus on some key areas that can really increase the value when you do go to sell. Aside from some of the quick fix activities that you can perform on your business including reducing non-critical operating expenses, cleaning up your balance sheet, and focusing on top line sales growth, here are some other useful tips:

First, clean up your business by re-setting your attitude. Many business owners are stressed out right now. Some are completely burned out while others are just plain cranky! As the leader of your business, what effect do you think all of this negative energy will have as it transfers down to each one of your employees and ultimately on to your customers? It’s certainly not a good thing.

Next, focus on providing the best possible customer service experience. Customers want to do business with companies that care about them and treat them fairly. For most industries, this is what will separate your business from your competitors especially in the new information age where upset customers can post their opinions online for all to see. Those companies that take care of their customers will be rewarded with positive reviews online, significant referral business, and ultimately a solid brand.

Finally, start looking at your business as if it were a franchise. Examine each area of your company very closely. You’d be surprised at how few business owners ever really take a look at the individual parts of their companies as time goes on. Most of them spend their days simply waiting for a problem to occur and then go into fire fighting mode to figure out how best to put a band aid on and move on back to business as usual. You might even put together a brief “Procedures Manual” outlining and documenting each area of your business (marketing, sales, customer service, fulfillment, operations, finance, etc.). This can be a great opportunity to find some immediate “quick fix” areas such as operating inefficiencies or potential growth opportunities. Also, when the time does finally come to sell, this can serve as a great tool for helping buyers understand all of the moving parts of your business.