by Joey Young | March 29, 2021
Editor’s Note: This is the second article of a four-part series.
In the previous article, we calculated the earnings before interest, depreciation, taxes, and amortization (EBIDTA) using the most recent tax return to arrive at what the business’ profitability is on paper. In this article we will adjust that number up and down based on a few items that impact profitability to arrive at the actual cash flow.
Sellers and business brokers might call the actual cash flow by several different names, such as: sellers’ discretionary earnings (SDE), owner’s cash flow (OCF), or simply discretionary earnings (DE). For our purposes, I will refer to the adjusted EBDITA as the OCF, because owner’s cash flow is exactly what we are trying to determine here. For a quick reminder, in the previous article our EBDITA value for a health club was determined to be $135,000.
For the EBDITA calculation, there wasn’t really much room to disagree on the adjustments to profitability that needed to be made, but these next items will require you to think a bit more carefully:
- Discretionary expenses: Discretionary expenses are expenses in a business that sellers often describe as unnecessary or perhaps wasteful. Some sellers try and show higher profitability based on the concept that the new owner won’t necessarily have some of the same expenses the previous owner did. You have to be careful about defining something as discretionary because it may in fact, not be discretionary at all. For example, if health insurance for employees is not required by law but has been an employee benefit for years, it cannot be called discretionary since the employees would probably all quit if you suddenly took it from them. Let’s say though that a health club business has been paying $3,000 per year for upkeep on the owner’s Harley Davidson motorcycle because he decorated it as a “World Gym” motorcycle, and it sort of serves as a rumbling billboard. That particular expense could rightly be called discretionary. Here’s a good discretionary test: If removing an expense changes the operation or the character of the company it is not a discretionary expense.
Example: The new adjusted profit would increase to $138,000, with the $3,000 per year upkeep on the Harley Davidson.
- Capital expenditures: Capital expenditures are reinvestments of equipment into the business that can tend to happen regularly or irregularly, and as a result are impactful to the cash flow. One great example of regularly occurring “cap-ex” is in a health club. A busy health club will have to replace its cardio equipment (treadmills, steppers, elliptical trainers) every five years or so. That equipment can cost $5,000 or more per item so a health club’s cash flow would need to be lowered somewhat to take into account that every five years, approximately $200,000 (or so) has to be spent on 40 new pieces of equipment.
Example: I would lower the gym’s adjusted net profitability by $40,000 per year to account for regularly occurring capital expenditures, making the new adjusted value $98,000.
Here is the potential negotiation you will face. A seller does not want to lower the actual cash flow with a capital expenditure adjustment because it lowers the value of the business, and therefore the price. But a gym has abnormally large capital expenditure expenses occurring on a regular basis. Capital expenditure amounts for small businesses are typically much smaller than $40,000 per year and occur irregularly. For a gym, I would stand by that subtraction of $40,000 from the OCF cash flow, and then just compromise for the capital expenditure on other irregularly scheduled things, like office equipment, to not be subtracted.
- Owner salary: Owners of small businesses are often also employees within the business. They manage employees, plan finances, clean bathrooms and work late doing all sorts of jobs for all sorts of reasons. In an OCF calculation, the owner’s salary is also added to the actual cash flow because it is another example of a transfer of money to the owner. Intuitively though you might think that an owner’s salary is actually an expense to the business because if the owner didn’t fulfill that manager’s role, someone else would have to. And you would be correct. But the reason we add the owner’s salary to the actual cash flow is because a later calculation will take that expense into account when determining an appropriate price for the business.
Example: Let’s assume that the previous owner paid themself $50,000 per year to be the gym’s manager. We then add that $50,000 and we arrive at $148,000 actual cash flow.
- Owner’s benefits: Sellers will try and include an owner’s cell phone, company car, and any other employee tool as parts of the OCF. Those items should almost never be considered to be extra cash flow. But why not? Because if you had to hire someone to do the current owner’s job, you’d have to equip them adequately and those items would still be considered an expense, not an owner’s benefit at all. My recommendation is to compare the current owner’s “perks” to what it would cost to equip someone else to replace him/her. If the owner is receiving more than that amount, add the “extra” amount to the adjusted net profit.
Example: We will add the owner’s company car expense of $6,000/year to the adjusted cash flow because typical gym managers don’t often insist on a company car, but we will not add back a company cell phone expense. So, we increase our adjusted cash flow by $6,000 to account for that owner benefit. The new adjusted cash flow is $154,000.
- How replaceable is the owner in the business? Some owners have very specific skill sets or licenses that enable them to perform their job. If you don’t have access to those licenses (for example: a license to spray pesticides or to build fire sprinkler systems), you’ll have to hire someone who does have those qualifications and then deduct that additional annual expense from the adjusted cash flow.
Example: No real licenses are needed that any owner couldn’t easily and cheaply acquire and we won’t adjust net profit for this item. The adjusted cash flow remains $154,000.
In our next article we will see how you can take that $154,000 OCF and determine an appropriate price for the gym you intend to purchase and then also define the often-misunderstood concept of goodwill.