Question:
What exactly does the term "Cash Flow" mean?
Answer:
GREAT question! Cash flow is probably the most frequently misused accounting term I can think of. Cash flow is NOT profit. First, understand that "cash flow" as a term for valuations is far more applicable in large business transactions, and not smaller ones where the buyer will be taking over from the former owner.
In its purest form cash flow means: "the amount of cash that the business had at the beginning of a period, what it had at the end of a period, and what happened to the difference."
You're probably going to come across this term during your search to buy a business in numerous locations such as business for sale Websites, financial statements, broker listings, etc. It is imperative that you get a breakdown of what is included in this so called "cash flow" number. More than likely, it is not the correct terminology for the figure you will review. What is often referred to as cash flow in small businesses for sale is actually the Seller's Discretionary Cash Flow, Adjusted Income/Profit or Owner Benefit figure. This is typically the total of net income, owner salary, perks, depreciation, interest, and non-recurring expenses. (By the way, it should also include a provision for capital expenditure allocation, but that's a whole different discussion.) As you can see, there is an enormous difference between what cash flow actually is, and what is represented to a buyer.
Question:
In determining the value of a business, how important is it to consider the earnings percentage - i.e. earnings as a percentage of overall revenue? All things equal, if I'm looking at businesses with a certain amount of earnings, am I better off with a business with lots of revenue, and relatively low earnings percentage, or a business with a high earnings percentage and much lower revenue?
Answer:
These are all excellent questions! I think it's difficult to simply broad-brush an answer to you specifically because different businesses/industries will have a wide range of earnings as a percentage of revenues.
As an example, service business will typically enjoy enormous margins compared to distribution companies. Therefore, if you wish to have this figure play a significant role, your only considerations should be: is the net profit percentage after add-backs in line with industry standards and, second, how do the profits of one compare to similar businesses?
The question of which is better, higher profit percentages or revenue is strictly a matter of personal preference. I certainly prefer businesses that have higher margins, and I am less focused on the revenues. In fact, of my five golden rules that any business must have, high margins is one of them (the other four are: sales and marketing-driven, element of exclusivity in product/territory, demand in place, don't compete on price).
The reason why high margins are more important to me is because my strength is in sales and marketing. I know I can build a business' sales, and so if the margins are strong, the profits will surely follow. Conversely, it is difficult, if not impossible to significantly impact the margins of a business. Sure you can cut expenses, but the only long-term meaningful way to build a business is to grow the revenue. Therefore, if the margins and profit percentages are good, you'll experience meteoric increases in profit as you significantly increase sales.
So in a long-winded way, my preference would be to pay more attention to the profit percentages unless you're considering an industry with traditionally low margins and one that you are very familiar with operating.
Question:
How can I get the value of assets required for the business, such as transportation business? What is your take on taking over the remaining balance, payments on assets?
Answer:
You raise a very good point; however, the question is why you need the valuation specifically? Is it to secure financing? If so, most local dealers can be of assistance to you or the lender. On the other hand, if you simply want to learn if the assets you may be acquiring are worth what they're on the books for, then you may want to look at it from another angle, which is to determine the road-worthiness of the vehicles and tractors and other equipment to determine when they will need replacing. You must also investigate the maintenance records of each asset.
Many prospective business buyers have an incorrect view of the business' assets. I believe that the assets are nothing more than a vehicle (pardon the pun) to generate revenue. That is why you need to learn what the replacement costs are and when you'll be faced with making them, as this can severely impact your cash flow.
Insofar as taking over payments on assets, it really depends on the business deal itself. Usually, you're far better off to complete the purchase as an asset sale, and get all the assets "free and clear", which will allow you to step up the value of each and depreciate them again as long as the purchase price is allocated properly (your accountant can assist you with this point). You may not enjoy the same depreciation schedule if you just take over the payments.
Question:
When brokers say that taxes can be added back to get a "net-profit" number would that also include sales taxes for a retail business?
Answer:
You bring up an excellent point. When you add back taxes, along with other standard "add backs", your objective is to obtain a figure for the total Seller's Discretionary Income (sometimes referred to as Seller's Discretionary Cash Flow, or Adjusted Net, or Owner's Benefit). You do not add back any sales taxes because that is not money that you, as the new owner, would have available after expenses to pay yourself a salary and service any debt. When looking at a business' financials, you want to be certain that the revenue number being represented is net of sales tax. If by some chance it's not, then you must check that there is an expense item for sales tax.
When it comes to sales taxes, the business is simply an "agent for the government" (sounds pretty neat) to collect and remit the taxes and so the inflow and outflow of the taxes is an accounting function only.
Question:
What is a common practice for dealing with accounts payable/receivable when purchasing a business?
Answer:
In nearly all small business sales, the seller will retain the cash and accounts receivables. They will pay off the payables, and deliver the business "free and clear" to you.
In larger purchases, the buyers will likely acquire these balance sheet items to provide them with immediate working capital. However, unless it is an especially large or complicated deal, you will usually not take the AR at closing.
With this being the norm, be certain that you have ample working capital available.
Question:
I'm interested in buying a business some day, but I have a question about return on investment calculations. When calculating owner benefit/cash flow, do you subtract out a reasonable salary for the owner first and keep everything else that flows to the owner (assuming your position as an owner is a full-time job) or does the total owner benefit calculation typically include owner salary?
If you don't subtract out a reasonable owner salary, aren't you really calculating a return on your capital investment plus your time investment, and not a true ROI? Put another way, comparing small business multiples of owner benefit with that of publicly traded companies would be apples to oranges because you don't need to give up your current job and income to invest in the stock market. If owner salary is not typically subtracted out, why isn't it?
Answer:
This is a very perceptive question/observation and there are two schools of thought. Before discussing them, you should be aware that calculating your ROI is not to be confused with determining the business valuation (we’ll discuss that in a moment).
In the first approach, from strictly an investment point of view, it would seem to make sense to deduct a salary for a manager from the Owner’s Benefit and therefore determine your ROI compared to other potential investments.
The second approach looks at this from the individual’s perspective, meaning that you as the buyer and future owner/operator do not reduce the Owner’s Benefit for a manager and rather evaluate this as an opportunity compared to other “job” opportunities that you can consider.
Personally, I am a firm believer in the second approach because buying a business is your chance to forever say goodbye to working for someone else, to grow the business, and ultimately, sell it one day for a multiple of the Owner Benefit. Add to that the fact that you will clearly control your own destiny far more than any impact you could have investing in a public company.
Having said that, I do recommend that you evaluate your ROI including a manager’s salary to be certain that it fits within the acceptable boundaries based on your cash investment. For example, let’s say you that you are looking at a business that is generating $100,000 of Owner Benefit, and selling for $250,000 with $125,000 of seller financing (this scenario requires a $125,000 down payment from you). Assuming you hire a manager for $40,000, this will leave you with $60,000 to service the debt and pay yourself. Assuming a five-year seller note at 8% including Principal and Interest, the annual debt payment will be around $30,000, leaving you $30,000. Calculating the ROI on your cash investment (of $125,000) this will provide you with a 24% return, which is just slightly below the targeted 25% - 33% desired return for buying a business. However, once the debt is paid, and assuming all things remain equal, you’ll generate $60,000 against your $125,000 cash investment, which brings a 48% ROI.
In summary, you simply need to evaluate the risk versus other investment possibilities.
That aside, let me restate that you will be buying a business to build YOUR future. While you may wish to calculate your ROI by including a manager’s salary, I do not feel it is appropriate to conduct your valuation with this net number. The valuation of a small business should be done based on the buyer replacing the seller and therefore having the benefit of the entire Owner Benefit figure (assuming all things remain the same after the purchase). While your point about investing in a business versus getting a job makes sense at the surface, I know that it is rare to have a job where you have absolutely no limit to the potential upside like you will have as the owner of a good business.
Your point about public companies is correct: you cannot compare multiples to those of a small business. However, the interesting thing about the huge gap between these two scenarios is that should you grow the business to a point that it may be attractive to be purchased one day by a public company, you can hopefully obtain a much higher multiple through the accretion that the buyer will achieve.
Question:
If you buy a business that includes the Accounts Receivable (A/R) do you discount this amount? If so, are there certain percentages that are common for certain industries?
Answer:
While most small business sales are "asset sales" where the AR generally remains with the seller, when the buyer does take the AR, there are a number of considerations.
The main priority of course is to be certain that the AR is collectible. To that end, it may require you having the ability to offset or reconcile any uncollected amounts and generally, anything past 90 days can be considered uncollectible.
The DSO (Days Sales Outstanding) is generally the guide for any discounts, as opposed to something industry-specific. Naturally, if you can discount the AR across the board it is advantageous for you; however, there must be an equal benefit to the seller or else they will just collect it themselves. Usually I like to work towards a 90 – 100 percent value on current AR (under 30 days), a 20% discount between 31- 89, and then leave anything over 90 days on an "as realized" basis. In other words, if collected, the seller is paid; if not, they are not compensated.
By: Richard Parker: President of The Business Buyer Resource Center and author of How To Buy A Good Business At A Great Price©