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“Cash Flow”: What the Heck is it, in Buying a Business?

February 7, 2012

This is an important discussion, whether you are buying or starting a business, yourself.  But it is a term that is more frequently used whenever you analyze a business to purchase.  In buying, the Seller or Broker will often quote a Dollar amount that is termed the business’ “Cash Flow”.  This term is frequently misunderstood by Buyers – and even by Sellers and Brokers, themselves.

Keep in mind that we are not Accountants, we do not pretend to be Accountants and we do not even play Accountants on TV!  The discussion provided here must be viewed in that light; however, the term “Cash Flow” is quoted in any number of documents and reports as a “non-GAAP” financial measurement, anyway.  (GAAP itself is defined as the Generally Accepted Accounting Principles by which Accountants operate.)  Cash Flow is utilized as a term most frequently by non-Accountants, as well.  You see it in the vast majority of advertisements and other promotional materials, when Sellers and Brokers offer businesses for sale, but also in more technically oriented documents such as quarterly and annual reports from some of the Country’s largest companies.  But in those latter documents, Cash Flow is normally, specifically labeled as a “non-GAAP” measurement of financial health.

That’s not to say it is an invalid measurement; but what it does mean is that it is something that has a wide variety of definitions and you, as a potential business Buyer, need to understand what each individual Seller or Broker is using to measure his/her definition of Cash Flow.  The absolute only way to do that is to ask each individual Seller or Broker, whenever you inquire about a business, in depth.

We are really going to discuss what Cash Flow means to the average Business Owner and Broker, (contrasted with what might be meant in a public company’s Annual Report,) with the emphasis that even here, there are broad variations in definitions.  The Seller or Broker should be able to explain him/herself in great detail and that is your absolute key.  If you get vague answers, back off of the deal.  They either do not know what they are doing, or more worrisome, they are hiding something with the intent of misleading!  The Seller or Broker should be able to tell you, and give you in writing what has been added or subtracted in a Cash Flow report, and why.

Cash Flow is not even a universal term.  Brokers will frequently label the same Dollar amount as “Sellers Discretionary Cash” (SDC).  EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) which is a more descriptive term than any of the others.  But it is not necessarily as all-encompassing as what is normally thrown into either Cash Flow or SDC.  There are many, many other terms used by many, many individuals, particularly in small businesses.  So again, you absolutely need to ask – and again, get the definitions in writing.

(We are currently involved in a C-Store negotiation, and the Broker admitted in advance that she was a novice.  She kept saying that the Seller was “making about $13k a month…”  The term “making” was vague, but in fact meaningless to us:  Was that Gross?  Net?  Adjusted Net or Cash Flow?  She was terrific in answering all questions in what she meant in great detail, and certainly was not hiding anything.  But the example demonstrates that lots of people use lots of different terms, none of which are standardized and demand clarification.)

Generally speaking, Cash Flow is comprised of, Net Profit, ideally as claimed in the Seller’s Tax Returns, plus Adjusted Expenses such as:

  • One-time items purchased by the Seller, which either would never to be replaced, or would not need to be replaced within the next number of years.
  • Expenses that the new Owner will not inherit, like the loan the Seller is paying off for when he/she bought the business; the Buyer will have his own loan, but the Seller’s own loan will be retired with the settlement, as will his payments.
  • Non-cash expenses, such as depreciation and amortization.
  • Some Tax Expenses.  (This is where your Accountant is invaluable!  In fact, your Accountant should review and approve of all of the items claimed as adjustments, by the Seller or Buyer.)
  • Any payments the Seller has made that are absolutely not part of the business expenses. (We once saw three salaries in a business, but no employees; I asked the Seller about it and he said those were he three grandchildren, all of whom were in kindergarten, first and second grades.)

This last issue is where arguments usually start. There are some adjustments that should not be legitimate business Expenses, but extracting them and proving they are not germane to the operation is difficult, if not impossible. The Seller that argues that issue is not very wise, in many instances.  For one thing, these individual items are frequently not terribly large, and pushing the Buyer to accept that will frequently create more of an air of suspicion or negativity than they are worth.

Even if those Expenses are not part of the business, Buyers will not be able to get any lender to agree to honor those adjustments, when the bank is using the Cash Flow for the purpose of granting a loan.  Moreover, if the Seller puts this in writing, he/she is opening him/herself to scrutiny from the IRS, which could very well then see such comments as a confession to Tax Fraud; the Broker that cooperates could have some liability in this area, as well.

Some Sellers/Brokers put the Seller’s entire Salary into the adjustments. This is not wrong, but the Seller/Broker should disclose this in advance, and the Buyer should know that this needs to be adjusted again for him/herself, when applying for a loan to fund the acquisition.

In a loan application, a Pro Forma P&L will be requested from the Buyer.  This is a projection of profitability the Buyer can anticipate during the first three (3) years or so of operation, once he/she takes over.  It further demonstrates to the lender that the Buyer understands the financial situation he/she is attempting to undertake, and that sufficient money will be available to make payments on the loan.

In an SBA-backed loan, you would invariably be asked to complete a form that shows your own personal, monthly expenses.  It will ask what you are paying for Rent/Mortgage, Utilities, Car Payments, Charge Cards and other fixed obligations.  That number will be subtracted from the Cash Flow to let the lender know whether sufficient Cash remains, in order to allow you to make your loan payments.  So, you need to know whether the Seller’s/Broker’s numbers contain the Seller’s Income information, which would allow you to make allowances (if needed) to subtract the Expense for the Seller, and insert your own financial requirements.

The Seller’s Fringe Benefits are another area that need to be understood.  As a general rule, if the Seller has established IRA or other Retirement programs for himself and for which the Company is paying, these are added to the Cash Flow.  You can determine whether that is something you want to do on your own, as the new Owner, but you are not paying into the Seller’s Retirement fund, so this amount will cease, once you take over.

Health Insurance is commonly added back in, as well.  You may need to obtain your own Health Insurance, but you also may be on a policy through your spouse’s employer, so it is something that may or may not be a requirement for you.  If it is not specifically required to continue the daily operations of the business, the Seller/Broker is completely justified in adjusting such an Expense and adding it to the Cash Flow total.  BUT THEY NEED TO BE ABLE TO DISCLOSE AND EXPLAIN THEIR METHODOLOGY!

IDEALLY, the Cash Flow number that you receive from the Seller or Broker should be your (the Buyer’s) Income BEFORE you deduct your own Salary, Benefits and Debt Service.  After that, what remains is a projected Loss or Profit.

*  * *  Again:  This is not an Accounting discussion; this information is what you, as a Buyer should use in determining whether the business you are considering is potentially worth pursuing.  In ALL cases, you should take this information to your Accountant to verify your findings, as well as the claims made by the Seller and/or Broker.  *  *  *

Also, be very careful to understand that all Cash Flow and the resulting Pro Forma P&Ls you create in using such information, is based on historical data; it is the result of the Seller’s own activity and methods of operation.  Cash Flow is used as the basis for pricing the sale of many small businesses.  There is absolutely no guarantee that you will experience the same profitability, when you acquire the business.  If you do not work the business properly, if you figure that the business is on “cruise control”, because of the number of years it has been in business and potentially been profitable, there is every reason to believe that its earnings will erode, under your ownership.  This is why Sellers are so hesitant to offer financing on the sale of their businesses.

The economy of the Country can change, as it did in 2007-8, and many mature businesses faltered, as a result.  The historical Cash Flow went out the window, through no one’s fault.

Your task, as a Buyer and in a close working relationship with your Accountant, is to use your best understanding of the Seller’s numbers, the industry the business represents, and current and projected economic cycle in which you find yourself, as well as any other characteristics you can identify, and determine the affects all of those issues might have on future operations and your own projected Cash Flow.  This is the basis for understanding whether the asking Price is fair, and if not, what offer you would ultimately make.

The Seller can ask any Price he/she wishes to make; but the Selling Price is solely what the ready and able Buyer is willing to pay.  Your offer should be based on all of the information cited, above.  In many cases, the offer will be lower than the Seller asks.  He/she can accept your offer, counter it with another offer of his/her own, or reject your offer completely and tell you to never come back!  In making your offer, you should be prepared to offer objective reasoning, since that may ultimately be the basis for further negotiation.  And be aware that in some cases, Terms are regularly exchange – both upwards and downwards – for Price.

Future financial performance, as represented in the Pro Forma P&L and derived from information in historical Cash Flow reports, is not always negative.  In fact, it is frequently very positive.  If you cannot show your ability to maintain, increase and improve the business, then something is wrong.  It may be a bad business.  It may be a bad business for you.  It may be that your methods are incorrect.  One way or another, do not buy it!

We sold a very large and successful Deli, that had been owned by the same man for more than thirty (30) years.  His history had gone back even further because he had worked there as a teenager and had bought it from the original Owner.  But our Seller’s numbers, (though very good, at $1.6 million per year for a six-day-a-week operation,) had stagnated over the last several years, largely because of the Seller’s age and increasing health problems.  The market itself, appeared to be very positive and growing.

We brought him a Buyer with a strong background in Deli operations.  He was a native ofNew York City, the epicenter and hallowed ground, for Delis.  The Buyer purchased the business at a fair price and introduced a much greater variety of Catering services, as well as more aggressive methods of promoting them.  He just called us, four (4) years later, wanting to sell and get another location, closer to his home.  His current Revenue is $4.2 million!

A huge consideration in buying a business should always be to determine what has been done in the past, and what you can bring to that business, in order to maintain the historical base, and improve or grow it for the future.  It can be said that Revenue measures the goodwill represented in the business, while Cash Flow can be a measure of the efficiency of the management.  As a Buyer, Cash Flow – or whatever you call it – is a key determinant of what you need to do to understand the business’ past, and what you can do in the future.

But you first need to understand exactly what the Seller/Broker means, by Cash Flow.  That is the foundation for all that follows.

(The BAF Group LLC is a full service Business Brokerage, with a history of more than a decade of service. Its Principal Broker possesses 25+ years of Business Sales and Divesture. Although most of our work is involved in the Mid-Atlantic States, we have represented Sellers and Buyers throughout the Continental USA, and a number of overseas Buyers, as well. Some of our listings and additional information about us can be viewed at www.bafgroup.com. Thank you for your interest.)

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4 Comments
  1. Sean permalink

    Thank you for this information. Very informative.

    Like

  2. Sean permalink

    Thanks for the information Don. Your posts are very informative and go a long way in helping buyers and sellers understand some key concepts. I also appreciated the advice you personally have given me and suggest anyone in the market for a broker utilize your services. If this was amazon you would get 5 stars in my book.

    Like

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