Wayne Unze, Director of Business Brokerage at Maestas & Ward Commercial Real Estate
Pricing a business for sale requires evaluating its cash flow—another name for a business’s earnings before interest, taxes, depreciation, amortization and owner’s compensation are subtracted. Cash flow is then multiplied by a number that falls within a range appropriate for the industry and market—a number that takes into account other variables that affect the business.
But unlike multimillion dollar enterprises, small businesses often find much of their cash flow goes toward the owner’s compensation (salary and benefits). To accurately determine a small business’s true cash flow, its owner’s total compensation package must be removed from the equation to reveal essential operating expenses and thus avoid undervaluing the business.
The easiest and most widely accepted way to do this is to add all components of the owner’s compensation — things like health insurance premiums, salary, auto lease and profit sharing — to the earnings before interest, taxes, depreciation and amortization (known as EBITDA). Other additions might include non-recurring expenses such as one-time moving expenses; however a seller must be able to prove all the cash flow components. This means any expense he maintains is not business-related or is personal compensation must have a receipt or other validating document supporting the claim.
This revised cash flow sum is multiplied by 2.0 or 3.0 to arrive at a range of business value; if the resulting number is less than the current value of the business’s assets, the asset value then becomes the company’s true value. The cash flow multiple can be increased somewhat if cash flow exceeds $300,000 and even more when it passes $500,000 since more debt can be serviced at that level.
Other factors that can influence the value of a business are age and condition of equipment, real estate owned by the company, age of business and history of profits, among other things.
Here’s a sanity test to employ when trying to decide if a business is fairly priced: After a typical down payment of 30 to 35 percent, the business’s cash flow should be able to retire the balance of the debt while providing the buyer an adequate living wage.
To illustrate this equation, let’s say ABC Inc. has a net profit of $30,000 on sales of $600,000. For an accurate number of this business’s value, consider that the business’s operating expenses include the owner’s salary ($50,000), his health insurance premium ($5,000), his profit sharing ($20,000) and his leased company car ($7,000 per year). Other cash flow components in the operating expenses include interest payments of $10,000, depreciation of $25,000 and amortization of $3,000. When these operating expenses are added to the net profit, the cash flow of this business is a respectable $150,000. Multiply that number by two or three, and ABC Inc. is worth between $300,000 and $450,000.
If the buyer put down $150,000 (one-third) on an offer of $450,000, the debt service would be about $4,528 per month on a seven-year payout at 7 percent annual interest (standard terms). After servicing the $54,300 annual debt, the buyer would still have about $96,000 remaining as his compensation package and return on his initial investment.
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FAQs
Studies show that one of the top reasons most businesses fail is because they don't have enough cash on hand. Cash flow management lets you forecast expenses, prepare for dry months, and even know what to charge your clients.
What does cash flow mean when buying a business? ›
What is Cash Flow? Cash flow refers to the net balance of cash moving into and out of a business at a specific point in time. Cash is constantly moving into and out of a business. For example, when a retailer purchases inventory, money flows out of the business toward its suppliers.
Why is cash flow most important? ›
Positive cash flow indicates that a company's liquid assets are increasing. This enables it to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges. Negative cash flow indicates that a company's liquid assets are decreasing.
What is the importance of cash in a business? ›
Cash is the lifeblood of a business, and a business needs to generate enough cash from its activities so that it can meet its expenses and have enough left over to repay investors and grow the business. While a company can fudge its earnings, its cash flow provides an idea about its real health.
Why is cash flow important for startups? ›
Cash flow can demonstrate to investors whether your company needs to fill a funding gap to fuel its growth. Additionally, a neat cash flow can prove to investors that your business is financially sound, that you are on top of your finances, and that you won't immediately burn through the money they give you.
What is an example of a cash flow in a small business? ›
Examples of operating cash flows include sales of goods and services, salary payments, rent payments, and income tax payments.
How much cash flow is good for a small business? ›
As a general rule of thumb, it's recommended that businesses have at least three to six months' worth of cash on hand to cover operating expenses if possible, though you should make sure your business can afford whatever amount you set aside.
What are the three types of cash flow in business? ›
There are three cash flow types that companies should track and analyze to determine the liquidity and solvency of the business: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. All three are included on a company's cash flow statement.
What cash flow tells you? ›
A cash flow statement tracks the inflow and outflow of cash, providing insights into a company's financial health and operational efficiency. The CFS measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
What has the biggest impact on cash flow? ›
If your business normally extends credit to its customers, then the payment of accounts receivable is likely to be the single most important source of cash inflows. In the worst case scenario, unpaid accounts receivable will leave your business without the necessary cash to pay its own bills.
Cash flow statements, on the other hand, provide a more straightforward report of the cash available. In other words, a company can appear profitable “on paper” but not have enough actual cash to replenish its inventory or pay its immediate operating expenses such as lease and utilities.
What is the most important cash flow activity? ›
Answer: The operating activities section of the statement of cash flows is generally regarded as the most important section since it provides cash flow information related to the daily operations of the business.
What is the target of cash flow? ›
Cash flow targets are the ideal cash reserves your business should have to hand at any moment in time. This amount must balance the amount and timing of your anticipated cash inflows and outflows against the opportunity costs of setting aside too much cash.
Why cash is better for small business? ›
Consider Paying in Cash When Shopping Small
By the end of the year, if the owner makes $100,000 in sales through credit cards, an average of $2,500 would go to card processing fees. "Cash also allows business owners immediate access to their money, without having to wait for processing.
How do you manage cash flow? ›
Best Practices in Managing Healthy Cash Flow
- Monitor your cash flow closely. ...
- Make projections frequently. ...
- Identify issues early. ...
- Understand basic accounting. ...
- Have an emergency backup plan. ...
- Grow carefully. ...
- Invoice quickly. ...
- Use technology wisely and effectively.
Small companies are exempted from the essential to prepare cash flow statements as part of financial statements.
Why is a cash flow forecast important for a small business? ›
A cash flow forecast is a vital tool for your business because it will tell you if you'll have enough cash to run the business or expand it. It will also show you when more cash is going out of the business than in. Follow these steps to prepare your cash flow forecast.
Why is it important to manage cash flow in a business? ›
Efficient cash flow management allows a business to optimize its working capital. By minimizing the time between receiving revenue and paying expenses, a company can improve its operational efficiency and reduce the need for external financing.
