When it’s time to sell a business, or if you’re looking into buying one, the Owner’s cash flow is often one of the most important parts of due diligence. Owner’s cash flow, often known as Seller’s Discretionary Earnings (SDE) for smaller businesses and adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization) for larger, mid-market businesses, helps determine the correct selling price. For smaller businesses, SDE is the best way to measure how much the total income the business has, as well as the benefits the owner receives. EBITDA is used more often for larger businesses that have a full management team in place. Understanding the Owner’s cash flow and how it’s calculated can help you determine how much your business may be worth or whether it’s a good idea to purchase a business you want to buy.
What is Cash Flow?
Cash flow is commonly thought of as the revenue of the business minus any expenses the business has, minus any additional working capital and money for capital expenditures that needs to be left in the business. The Owner’s cash flow is the income before deducting the owner-related expenses like their compensation and benefits, the discretionary expenses, depreciation, interest, taxes, and more. The Owner’s cash flow is the money available to cover the Owner’s income, debts, and the capital needed to run the business. Other adjustments can be made for non-recurring expenses, such as one-time lawsuits, and certain expenses like non-operating income will be adjusted out before the cash flow is calculated. This gives potential buyers a clearer picture of how much they’d receive in compensation yearly from the business, as well as how well the business is currently doing and expected to do in the near future.
What’s Included in Cash Flow for a Business
Cash flow is determined by breaking down the income and expenses for the business to determine what’s left. Accrual accounting will commonly have cash flow statements for an investor/buyer to examine while, with cash accounting, these are rarely provided, since cash accounting is based on when revenue and expenses are actually received or paid. However, “free” cash flow is one of the most important concepts in valuation. While SDE and EBITDA are proxies for cash flow, they’re often not great proxies. First, it is possible to determine the cash flow on a monthly basis to see how much money is being made each month. This also helps the new owner determine what they will receive for income and related benefits. Is this consistent each month? While it certainly doesn’t have to be, as some businesses are seasonal, it is important to plan for this, if you are a buyer. Start by calculating the total income of all cash sales and any credit sales, commonly known as accrual accounting. If this is not available, the cash accounting statements will have to do, but you should know that cash accounting is dependent on when the money flows in and out, versus when the transactions are completed. It’s important for a buyer to think about free cash flow by doing the actual calculations. Next, determine the cost in material and direct inputs for labor for the goods sold by the business to determine the monthly amount spent on materials and labor, commonly known as cost of goods sold. Deduct this amount from the revenue, as well as any other costs or expenses through the month, such as payments for labor, rent, and more, commonly known as sales, general, and administrative (SG&A) expenses. Finally, does the business have rising credit sales or inventory costs? You may need to subtract changes that stem from additional working capital that’s needed to finance a growing business. How about the principle on debt repayments? This is captured under cash flow from financing activities. Finally, are there upcoming equipment purchases or replacements that are needed? These are known as capital expenditures. Once all money spent has been subtracted from the money coming in, versus the money coming out, the resulting total is the free cash flow of the business.
Why is it Important to Know the Seller’s Cash Flow?
Free cash flow is important because it’s exactly the way it sounds, “free”. A new owner can take dividend/distribution payments for themselves or re-invest that money back into the business to grow the business even more. The Seller’s cash flow is an indication of how well the business is doing and how much the buyer can expect to get from the business once it’s purchased. If the Owner’s cash flow is low, the buyer may have to do a lot of work to increase the cash flow. Hence, they may decide not to purchase the business. Some of the reasons it’s a good idea to know the seller’s cash flow include the following.
- Determine Discretionary Funds – Sellers want to be able to show that the Owner’s cash flow is positive, so the buyers can see exactly how much income they may receive from the business and what discretionary funds are available to use as needed.
- Make Sure Debts are Covered – Sellers can use the cash flow to show that debts are covered with the income the business receives, so the buyer won’t be throwing money into the business to try to save it.
- Increased Chances to Obtain Future Loans – Buyers may want to take out loans to improve the business, which can’t be done without a positive cash flow that can cover the new debts. By having a positive cash flow, sellers can show buyers that there is room for growth.
- Income- Most buyers need something to live of off, so they want to know that there is money available for their personal expenses.
Improving Cash Flow to Prepare to Sell a Business
Sellers may want to start looking into ways to improve cash flow before they prepare to sell a business. This way, they can show potential buyers that the business will provide a significant income and that it will be worth purchasing for the asking price. There are numerous ways to improve cash flow, including the following.
- Improve the Inventory – Carefully think about the amount of inventory for products that sell well and reduce the amount of inventory on hand for products that don’t sell as quickly. This helps reduce overhead, as there’s no need to spend capital on items that just aren’t selling.
- Negotiate Reduced Material Costs – Talk with suppliers to see if there is any way to reduce the amount spent on materials or products purchased. It may be possible to receive bulk discounts and save money. Many sellers fail to shop around to see if suppliers will compete against each other.
- Increase Prices of Products – While business owners may be worried about increasing pricing and driving away customers, this is one of the best ways to improve cash flow. The increased price may not make a difference to buyers, so it may not impact the number of sales. While this is an important step that requires much thought, a Seller should increase prices at least commensurate with the cost of inflation, if not higher.
Looking into Cash Flow as a Buyer
Buyers will want to do their due diligence. During due diligence, buyers will check the Owner’s cash flow to see how much “free” cash flow is available from the business. Is it worth the purchase price? Cash flow is a good indicator of how well the business is doing, so if the cash flow is low or negative, it may not be a good deal. If the cash flow is positive, however, and there looks to be room to improve it further, buyers may see it as a great deal and be more willing to purchase the business.
If you’re a Seller and you’re thinking, “How do I sell my business?”, make sure you understand your Owner’s cash flow and how this could impact the sale, as well as the sale price when you sell. Talk to a business broker today about your business to learn more about how the Owner’s cash flow can impact the sale and what you can do to improve it before the business goes to market.