One of the most important areas for a business buyer to become knowledgeable when exploring the purchase of a business for sale opportunity is understanding how to calculate cash flow of a business.
Business owners report their company’s financial performance by using income statements, balance sheets, and tax returns. These documents will show the financial health and direction of the company. They show a business buyer how much money the seller is making in the business as well as what expenses go into generating the revenue. These reports are beneficial in determining the profitability and value of a business.
A business buyer must learn quickly that there is a disconnect in regards to small business financials. If you never learn this fact, the likelihood of buying a business is very slim. Many small business owners have the goal of using their business as a way of maximizing their lifestyle. One way of doing this is to also minimize the amount of taxes that are paid back to the government. Business owners often have expenses that cross over between personal and business. For example, a business may pay for the health care for the owner. It may also pay for the company car that also happens to be used for some personal usage. There are a number of items that business owners expense through a business. Some items are legitimate expenses while others are stretches by an aggressive owner. In either case, the financials need to be dissected to get a true understanding of the profitability of the business.
The process of dissecting is called recasting financial statements. This is also referred to as normalizing or adjusting the financial statements. It is an essential step in determining business value. A business owner's benefits such as salary, commissions, perks, incentives, personal loans and discretionary expenses are pulled out of the financials and added back into the earnings so a future buyer can assess the business, its cash flow and future earning capacity. It is the way of getting a true picture of the financial situation of the business. This amount then gives a business buyer the total amount of money that exists to service the debt on the loan when financing a business purchase, pay themselves a salary, and make a reasonable rate of return. Business brokers refer to this as seller discretionary earnings or cash flow.
Recasting the financial statements is the only way to have apples-to-apples comparisons with different businesses since each business is unique in the way they pull out owner benefits. If you are buying a company, it is a way to provide meaningful comparisons between the multiple business opportunities. Recasting also helps a business buyer identify items such as excessive and discretionary expenses and nonrecurring revenues and expenses as well as what opportunities are available to generate income in the future.