You know the words that can confuse, especially if you routinely watch Jeopardy.
Red, Read, Read
Met, Met (the latter is an abbreviation for the opera in NY)
These words either sound the same, though spelled differently, and have different meanings or are spelled the same, sound the same, and have different meanings. No wonder I have always had trouble with my own, English language!
One can elaborate on this point with English language for business.
There is Cash Flow and then there is Cash Flow. One has to take the cash flow in context to be able to interpret the real value to one’s deliberations.
I am going to the fair.
I am going to be fair.
It can be a huge difference and an unwary buyer can be fooled and a seller can be puffed up or deflated with out reason.
Here are just some of the differences:
Cash Flow to owner for a specific year – 1
– Recently another broker sent me a statement of cash flow to owner handwritten, for one year. It showed the net income for the business, added back the health insurance for the business owner (this makes sense) and $100,000 that was paid to a mortgage company. The latter is somewhat suspect. When the $100,000 was written the entry was from the checking account and charged to the owner’s draw. The checking account could have been accumulating this money over many years from unexpended revenues and now, in a single year, spending that money to pay a non-income statement entry.
This is list of cash expenditures NOT something to base the purchase of a business on – not without further explanation. In fact, I know that in this case, the Purchaser, if they based their purchase of the business on that single year of cash expenditures, they could pay as much as several hundred thousand MORE than the business was worth.
Cash Flow to owner is typically taken as the result of the bottom line of the business profit and loss statement and adding back items within the expenses or subtracting items from revenue that are contained within the bottom line but accruing to the business owner.
Cash Flow for three years
–The owner of the business is very excited because last year they had a great outcome. The net to owner was $150,000. And, because they read (or is it have read) journals, they believe the value of their business should be three times that net to owner or about $450,000. The net to owner two years ago was $100,000 and one year ago $80,000. This is a great variation and has to be understood. Is the business volatile due to changing practices, unusual sales events, or merely misapplication of sales into wrong years. These variations should be reviewed and understood by a buyer (not to mention the owner needing to understand.)
Do note that the three times net to owner is very hard to achieve for a sales price…though the journals say…
Cash Flow to manage money
– I am part of a non-profit board. We have a projected cash flow for a rolling twelve months to ensure proper management of our funds We want to anticipate when we might be cash short and manage prospectively not retrospectively. Business buyers absolutely should do this exercise so they are not cash short during periods of ramp up of receipts or large expenditures. It is a very important exercise, one I recommend is done routinely, even after the business and new owner have matured with each other.
Note that a rolling 12 months means we are always looking 12 months ahead, whether the first month is January, February, March, etc. What is behind us is immaterial to the question of ‘are we prepared for the future’ EXCEPT what cash the past has brought us for the future. In a rolling cash flow includes the cash left from the prior period at the very beginning and carries, if unspent, into each of the following months. One can not look at months and instead look at quarters, years, etc.
A simple example of a rolling cash flow
Cash Flow for retrospective understanding
– “Good grief, where did all of my money go,” says the beleaguered business owner. It is not unusual for an owner to be in dismay at the end of the year. They had more sales, saved on expenses and should have been in fat-cash city. But they are not. This is a time when a report from the bookkeeping system can be helpful. It tells you exactly where it all went. However, if it looks too good, look at the opening and closing cash position on the balance sheet and see if it is the same or different. You may be surprised…$20,000 gone. It may be gone for good purpose but it could also be putting you in a bad position for the future.
Cash Flow to owner for a specific year – 2/Accounting System Produced
– In this example a buyer does not understand the value of the business as portrayed by the owner and broker. The cash flow calculated from the income statement is $70,000. The owner has spent nothing on himself. The buyer asks for a copy of the statement of cash flows from the bookkeeping system. It shows this: $70,000 to income statement; $15,000 liability reduction; and $5,000 to owner draw. The buyer is very excited because, this is $90,000 of cash flow.
The question is, where did the money come from? What does this particular bookkeeping system report as cash flow. Was it cash in and cash out in the same year or period? Or was the additional $20,000 from a prior period, held in reserve for the purpose of spending in a subsequent period. If the buyer assumes it is a rolling cash flow from the prior year, then what does that do to the evaluation he has of the prior year? Does he have another way of looking at the current year.
Note: In this example, a broker independent of the transaction saw the $90,000 claim of cash flow and said, immediately, this does not make sense – perhaps they took money from a prior year.
In this last example, the buyer could be duped if he believes the cash flow of $90,000 is representative of the business of that year. He has to know more. Each of the examples demonstrate various considerations for the term cash flow and why three years at a minimum should be considered; why working from the income statement is preferable for small business valuations; and why examination of the entire picture is important.
Moral to the story?
Cash Flow, Cash Flow, Cash Flow – Know the context and use it well.