Understanding Owners Cashflow – buying and selling a Las Vegas business.
If you are thinking about selling your business, you need to understand what owners cash flow is and why its important to valuing your business. In my small business sales, the seller is the owner-operator and the new buyer usually intends to be fairly active in the business as well. Because this is the case, one of the best ways to measure the businesses adjusted net profit is to take the number shown on the profit and loss statement and “add back” the owner's benefits, including their salary.
Most small businesses are not trying to maximize profit shown on the profit and loss statement, unlike public companies. The owner is trying to take out or expense out as many expenses, be it personal or business, to lower the taxable year-end income. When buying a small business, it's important to realize this because if all you look at is their profit and loss statement, you might not find any small businesses worth buying.
When buying an owner-operator business, you’ll need to identify the “add backs” or personal, owner benefits, one time, non-recurring expense and add them to the bottom line of the business to get to what is called owners cash flow or adjusted net income or SDE (sellers discretionary earnings).
Owners cash flow is defined as the income before deducting the primary owner's compensation and benefits, other discretionary, non-recurring expenses, non-operating expenses, depreciation, taxes, and interest. This is the amount of money that is available to a buyer to pay off debt and provide operating or expansion capital to the business.
In order to accurately calculate this, you’ll need to use the sellers business tax returns, income statement and other financial records. It’s a little like a treasure hunt trying to match everything and find the true SDE.
In order for an expense to be considered discretionary, keep these items in mind:
1. The expense must be for the benefit of the owner – items like health insurance, auto gas, personal insurance, etc.
2. The expense can not benefit the employees or the business.
3. The expense needs to be verifiable and documented. Just because the owner says they siphon off $1000 a week in cash and use that to pay their personal expenses doesn’t mean we can use that. We have to be able to verify that the income came in and then the expense went out to the owner's benefit.
4. Finally, the expense must be verifiable as discretionary by the new buyer.
For example, if you count meals and entertainment but those meals and entertainment were used to network and grow the business, or if you count auto expenses when that auto was generally used for business purposes, you will have a hard time convincing anyone that those are discretionary expenses and will most likely not be added back.
Before you look to buy or sell a business, reach out to us. As a Las Vegas business broker, I specialize in business valuations and the buying and selling process. There is no cost to work with me unless and until we can get your business sold.