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.
Article 123
Download 123_Avoid Undervaluing Your Business PDF
FAQs
That's why a cash flow statement is essential for small business accounting: It's a financial statement that shows all the cash coming in and out of your business. A cash flow statement is one of the three primary financial statements that all businesses need, in addition to the balance sheet and income statement.
Why is cash flow planning important for a small business? ›
Ensuring a steady flow of cash through your business's veins means you can meet expenses head-on, such as pay employees and purchase supplies. More importantly, sufficient cash flow allows a business to plan and execute growth strategies without the constant worry of financial constraints.
How to do a cash flow projection for a small business? ›
Step-by-Step Guide to Creating a Cash Flow Projection
- Step 1: Choose the type of projection model. ...
- Step 2: Gather historical data and sales information. ...
- Step 3: Project cash inflows. ...
- Step 4: Estimate cash outflows. ...
- Step 5: Calculate opening and closing balances. ...
- Step 6: Account for timing and payment terms.
Lenders expect regular repayments on the financ- ing they provide. As such, lenders rely on a company's current and projected cash flows to determine whether it will be able to afford the additional debt. Overall, understanding a company's cash situation is crucial to making sound business decisions.
Is cash flow required for small companies? ›
Small companies are exempted from the essential to prepare cash flow statements as part of financial statements.
What is the average cash flow for a small business? ›
Findings. Go to finding 1The median small business has average daily cash outflows of $374 and average daily cash inflows of $381, with wide variation across and within industries. Go to finding 2The median small business holds an average daily cash balance of $12,100, with wide variation across and within industries.
What are the benefits of cash flow forecast for a small business? ›
One of the main reasons businesses forecast cash is because it allows them to predict future cash positions. Having an understanding of what your cash flow may look like in the near future will allow you to prepare yourself for what may come and to plan your next moves.
What is the most important cash flow for a business? ›
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.
How many businesses fail due to cash flow problems? ›
According to SCORE, 82% of small businesses fail due to cash flow problems. Cash flow is a blanket term that has many underlying roots. Cash flow is simply a metric that indicates how money is coming in and being spent at your business.
What is the most common reason for a small business to fail? ›
The most common reasons small businesses fail include a lack of capital or funding, retaining an inadequate management team, a faulty infrastructure or business model, and unsuccessful marketing initiatives.
The limitations of cash flow forecasts include being unable to account for changing costs, and the accuracy of when money comes into the business. Miscalculations will affect the business which could result in debt.
How to build cash flow? ›
Increasing Your Cashflow
- Bootstrap the Business.
- Talk With Vendors to Negotiate Terms.
- Save on Production Cost with Technology.
- Delay Expenses.
- Start a Partner Referral Program.
- Have Operating Assets.
- Send Invoices Early.
- Check Your Inventory.
Your operating cashflow shows whether or not your business has enough money coming in to pay operating expenses, such as bills and payments to suppliers. It can also show whether or not you have money to grow, or if you need external investment or financing.
What are the three activities in a cash flow statement? ›
The cash flow statement is typically broken into three sections: Operating activities. Investing activities. Financing activities.
What is an example of a cash flow in a small business? ›
Examples of cash flow include: receiving payments from customers for goods or services, paying employees' wages, investing in new equipment or property, taking out a loan, and receiving dividends from investments.
How much cash flow is good for a business? ›
When it comes to cash-flow management, one general rule of thumb suggests enough to cover three to six months' worth of operating expenses. However, true cash management success could require understanding when it might be beneficial to invest some cash elsewhere as well.
What is a good cash flow ratio for a business? ›
A high number, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities. An operating cash flow ratio of less than one indicates the opposite—the firm has not generated enough cash to cover its current liabilities.
How do I determine my business cash flow? ›
Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure. Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital. Cash Flow Forecast = Beginning Cash + Projected Inflows – Projected Outflows = Ending Cash.
What is cash flow in simple terms? ›
Cash flow is the movement of money in and out of a company. Cash received signifies inflows, and cash spent is outflows. The cash flow statement is a financial statement that reports a company's sources and use of cash over time.
