Cash Flow

Typically a buyer will average the last three to five years of cash flow to establish a basis for the future projection. Depending on the nature and volatility of the cash flow, the buyer may weigh later years more heavily and/or toss out extreme years from the average.

Before averaging the historical figures, the buyer will normalize (recast) the figures to put them on a basis for the business to be run by a professional manager. For example, these recast figures will include adjustments for excess compensation and perks of the owner, adjustments for non-recurring events and adjustments to market rate rents.

In addition, the buyer will add back any interest paid to determine the earnings before debt. (The buyer's debt structure will be different that the sellers.)

And the buyer will add back any depreciation and amortization (non-cash expenses) and make allowances for future on-going capital expenditures.

The buyer will use the resulting average cash flow figure (Earnings Before Interest, Taxes, Depreciation, Amortization, less Capital Expenditures) (EBITDA less CapEx) as a basis for valuing the business. This EBITDA less CapEx is a valuation buzzword in the buyer valuation world and is the definition of "cash flow" as used in this article.

Sellers frequently expect substantially higher earnings in the future than those indicated by past cash flows. Sellers can influence the buyer's perception of future cash flow by presented a well-reasoned argument and business plan documenting the future (highly recommended). Even so, the seller probably won't be paid for those future higher earnings until they actually occur. (This is called an earnout.)

Cash Flow is king in the buyer's perception of business value.

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