What Is Cash Flow in a Business for Sale?

Cash flow represents money moving into and out of a business. Unlike accounting profit, which is on paper, cash flow reveals liquidity for obligations and operations. Buyers are primarily interested in the cash a business can generate.

Understanding Cash Flow in Business Sales

Cash flow defines a company’s financial viability and operational efficiency. It differs from net profit, which uses accrual accounting. Accrual accounting recognizes revenues and expenses when earned or incurred, not when cash changes hands. This can mean a business appears profitable but lacks sufficient cash.

Cash flow focuses on actual cash inflows and outflows, providing a transparent view of a business’s capacity to generate funds. This makes it a reliable indicator for buyers, demonstrating the business’s ability to sustain itself, pay debts, and provide a return on investment. Buyers often assess three main types: operating, investing, and financing. Operating cash flow, from core daily activities, is most relevant for a sale as it reflects primary business function efficiency.

Common Cash Flow Metrics for Valuation

Cash flow metrics assess a company’s earning potential. Seller’s Discretionary Earnings (SDE) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are two widely used metrics. They help potential buyers understand the financial benefits from acquiring the business.

Seller’s Discretionary Earnings (SDE) is a metric primarily used for valuing smaller, owner-operated businesses. It reflects the total pre-tax cash flow and financial benefit available to a single owner-operator. The calculation typically begins with the business’s net profit before taxes. To this, certain expenses are added back, including the owner’s salary, benefits, non-recurring expenses, interest, depreciation, and amortization. SDE aims to present a clear picture of the funds an owner could realistically take from the business after accounting for necessary operational costs.

EBITDA provides a clearer picture of a business’s operational profitability, excluding non-operating and non-cash charges. It is calculated by adding back interest, taxes, depreciation, and amortization to net profit. EBITDA is commonly applied to larger businesses or those with professional management teams, offering a standardized metric for comparing companies across different capital structures and tax situations. Unlike SDE, EBITDA does not include owner’s compensation, focusing on inherent operational performance.

Normalizing Cash Flow Through Adjustments

Normalizing adjustments, or add-backs, modify a business’s financial statements. Their purpose is to present an accurate picture of ongoing operational cash flow to a potential buyer. These adjustments remove expenses or income specific to the current owner or non-recurring events that would not typically continue under new ownership.

Normalizing adjustments include non-recurring expenses like litigation costs, one-off repairs, or large equipment purchases not part of regular operations. Discretionary owner expenses are also adjusted, including personal car expenses, excessive travel, or salaries paid to family members not tied to market rates. Adjustments are also made for non-operating income or expenses, such as gains or losses from asset sales not central to the business, or market-rate adjustments for rent or salaries if current owner arrangements are non-standard. Clear documentation and justification ensure transparency and credibility with buyers.

Interpreting Cash Flow for Business Sale Decisions

Adjusted cash flow figures are central to buyers’ and sellers’ decisions. Buyers examine historical cash flow trends, looking for consistency, growth, and stability. Predictable cash flow indicates a secure and valuable investment, as it suggests the business can reliably generate returns.

Cash flow directly influences valuation multiples, impacting the selling price. Businesses with strong, consistent cash flow often command higher multiples. Working capital is also considered, representing operating liquidity needed for day-to-day operations post-acquisition. Buyers require a normalized level of working capital to ensure seamless operations. While cash flow projections are assessed, buyers scrutinize them against historical performance to gauge realism.