When an individual is buying a business, the owners cash flow (also called sellers discretionary earnings) is usually the most important number in terms of valuing the business. In an owner-operated business, the owners cash flow is all of the income and benefits available to a working owner. These are the salary and discretionary benefits (not needed for the operation of the business), and net income. In addition, depreciation is added back because it is not a cash expense and interest is added back because it is assumed the business is sold free and clear of debt. In other words, owners cash flow is the EBITDA plus owner’s salary and benefits.
It is common that when businesses are advertised for sale, the owners cash flow is advertised. Buyers look at it to determine how much income is available to pay their salary, pay off any debt to acquire the business, and what is left for a margin of safety. They also use it to determine a price to offer. A prudent buyer should look at this number and see if it is calculated correctly. A seller should have an accurate cash flow so that their price expectations are realistic. Here are some things to look at:
Capital Expenditures – Depreciation is added back. The usual capital expenditures should be deducted. This is the normal amount the business needs to spend to replace machinery or equipment that has become unusable – either functionally or economically. If the business has not been spending this amount, a larger amount may be needed to bring the machinery or equipment up to a reasonable working level. Rather than deducting this one-time expense from owners cash flow, it is better to consider this as a deduction from the price.
Timing – Be sure that the reported owners cash flow reflects the current operation of the business, not from a prior time when the business performed differently. If the business is cyclical, or the business has just had an unusual event that has caused a one-time spike, or drop, in owners cash flow, it may be more appropriate to use the average of the owners cash flow over a few years or a pro-forma calculation.
Rent – The reported owners cash flow should be adjusted to the current market rent. The rent being paid may not be the market rent if the business owner also owns the real estate. The owner could be paying a higher or lower amount than the market rent. If the owner will be the landlord, find out what rent the owner expects to receive. If you are the owner, adjust the owners cash flow to reflect the difference in the rent you expect to receive vs what the business has been paying. If the property is being sold with the business, the rent adjustment is based on the revised real estate expenses – mortgage, property tax, and any other expense that will change.
Payroll – Are there missing employees? This could be the case if the owner is working very long hours – such as 80 hours a week. You should deduct for the salary of a person, or persons, to replace some of these hours. Another example is the owner’s spouse doing the bookkeeping at no salary. The cost of a bookkeeper is a reasonable deduction. What is not a reasonable deduction would be the buyer’s planned hiring to grow the business. That is an investment that should pay off in increased sales and profits. Sometimes, when a buyer is going to be an absentee owner, they deduct the pay for a manager. If so, the resulting number is EBITDA, not owners cash flow, and an offer should be based on a multiple of EBITDA. Prices based on EBITDA use a higher multiple than those based on owners cash flow. Owners cash flow is based on a working owner.
Interest and Depreciation on Loans or Leases Assumed – In many cases, accountants convert the lease or loan payments for equipment or vehicles into depreciation and interest. If the buyer will be assuming any of these leases or loans, the related depreciation and interest should not be added back. These are expenses that the buyer will have.
The owners cash flow is usually the most important number in arriving at an asking price for the business or an offer. Be sure you are using accurate figures.