How To Conservatively Analyze The Cash Flow And Return On Investment (ROI)Of Any Business

In order to review financial data in a consistent manner the financial/investment industry has developed a standard process called Recasting, Normalizing, or Stabilization. This concept has been adopted by the appraisal industry, CPA’s, attorneys, bankers, the International Business Brokerage Association (IBBA), and the Small Business Administration (SBA) as the accepted approach to standardizing financial information.

Expenses that typically are adjusted/recast/stabilized/normalized and taken out of the Profit & Loss statement, to arrive at the "true cash flow", include owners salary, owners benefits (owner's life insurance, health insurance, pension plan), debt service, depreciation (non-cash expense), and charitable contributions. Other expenses may be adjusted based the unique business owners accounting methods.

The adjusted (stabilized) expense information is integrated with the original cash flow of the business to arrive at an adjusted cash flow (see examples below). This is the actual net cash benefit to the business owner. This adjusted number is referred to as Net Owner Benefit (NOB) and/or Sellers Discretionary Cash Flow (SDCF).

Most objective advisors agree that a business is only worth what it can produce in terms of current cash flow and future returns to the owner...not worth what a seller might want or need, nor what a buyer wishes it could be purchased for, nor worth what an advisor (attorney, accountant, brother in law, next door neighbor, etc) might "guess" it's worth...but is actually worth a multiple of the historical cash flow and the potential return on investment to whoever owns the business.

Buyers and lenders look at the ability of the business to earn a realistic salary for the owner for operating the business, while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC).

A common way to determine the Seller's Discretionary Cash Flow (SDCF) is by using an analysis known as EBITDA (Earnings of the business Before expensing the seller's Interest, corporate income Taxes, Depreciation and Amortization). Also deducted from the business expenses is any owner's compensation or benefits the company paid. The result of this analysis is to leave in the expenses any recurring, non-elective "core" expense that the buyer is likely to also experience when the buyer takes over the operations of the business.

The resulting Seller's Discretionary Cash Flow then represents the factor that then is usually used as a multiple in determining what the business is "worth", based not on the assets present in the business, nor on it's potential, nor on it's history/reputation/good will, nor on any factor but on it's ability to generate cash flow.

Multiples (or ratios) can be derived by comparing selected variables such as annual sales, gross profit and SDCF to the Sales Price. Due in part to the volume of transaction information, applied to businesses in similar industries, these multiples can provide a very accurate picture of valuation (as defined by the marketplace).

Regardless of the formal approach to valuation, and the calculated value of a specific business, the business is only worth what it can produce in terms of current cash flow and future returns to the buyer. Buyers and lenders look at the ability to earn a realistic salary for operating the business while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC).

Return On Investment Analysis For An Absentee Owner

Actual Case Studies of Recent Acquisitions of Businesses That Buyers Will Operate Absentee/Part Time

Item	Business Example (A)	Business Example (B)	Business Example (C)	Business Example (D)
Purchase Price	200,000	325,000	500,000	1,000,000
Buyer's Down Payment	(50,000)	(65,000)	(125,000)	(250,000)
Buyer's Acquisition Loan	150,000	260,000	325,000	750,000
Business Cash Flow*	70,000	145,000	160,000	315,000
Less Buyer's Annual Loan Payments**	(27,000)	(46,800)	(67,500)	(135,000)
Buyer's Annual Cash Flow After Loan Pmts	43,000	98,200	92,500	180,000
Less Manager's Salary	(30,000)	(20,000)	(30,000)	(50,000)
Buyer's Absentee Cash Flow	13,000	78,200	62,500	130,000
Absentee Cash Flow For 7 Years***	91,000	547,400	437,500	910,000
Plus Value Of Business After 7 years****	200,000	325,000	500,000	1,000,000
Total Financial Benefits To Buyer*****	291,000	872,400	937,500	1,910,000
Less Buyer's Original Down Payment Investment	(50,000)	(65,000)	(125,000)	(250,000)
Net Financial Gain To Buyer, 7 years	241,000	807,400	812,000	1,660,000
Return On Investment (ROI) During 7 Years******	482%	1,242%	650%	664%
Annual Average Return On Investment (ROI) Counting Cash Flow Benefits and Equity Return	68%	177%	93%	95%

Notes:

* Annual Business Cash Flow using EBITDA Analysis
** Buyer's annual Principal & Interest Payments, 7 Year Loan, Assumes About 7% Interest
*** Cash Flow After Paying Manager To Operate Business, So Buyer/Owner Can Be Absentee/Part Time
**** Assumes Business Will Be Worth No Less In 7 Years Than the Price Buyer Originally Paid. Assumes the Price Buyer Might Sell the Business For After 7 Year's Ownership, and/or Value Of Debt Free Business After 7 Year's Ownership
***** Adds (a) Absentee Cash Flow For 7 years and (b) Value Of Debt Free Business After 7 Years
****** Return On Buyer's Original Down Payment Investment Over 7 Year's Ownership

This analysis is based on the current owner's results. A different owner may experience different results due to different management practices.

This analysis is for absentee owners who hire a manager to operate the business. An owner-operator who serves as his/her own manager would not have the manager expense.

Information and data about the businesses, including financial records, are the representations of the buyer and seller. Broker disclaims any responsibility for its accuracy.

This analysis assumes that the buyer/acquirer will achieve sales and profits that are no less than the previous owner's sales and profits. If the buyer/acquirer of the business has less sales and profits, and/or if the buyer/acquirer increases the cost of the goods and services, and/or if the buyer/acquirer spends more on overhead operating costs, and/or if the buyer/acquirer does not maintain a mark-up on goods/services equal to the former owner, the above ROI conclusions would not be accurate.

If the buyer/acquirer achieves sales and profits that are more than the previous owner's sales and profits, and/or if the buyer/acquirer decreases the cost of goods, and/or if the buyer/acquirer spends less on overhead costs, and/or if the buyer increases the mark-up on goods/services, it's possible the buyer/acquirer could realize an ROI that is more than the conclusions shown above.

If the buyer/acquirer operates the business as an owner-operator, instead of paying a manager to manage the business, this "hands on" buyer/acquirer would likely have higher SDCF (Seller's Deiscretionary Cash Flow), higher total (ROI) Return On Investment, annually, and over the life of ownership.

To arrange a confidential, no-obligation consultaion to discuss Return On Investment, Equity Build Up, or any of the other fascinating, exciting possibilities related to owning your own business, you may phone ABMI at 913-341-6300 or register with this web site.

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