Cash Flow—What Is It and Why Is It Important When Valuing a Business for Sale?
Cash flow is the movement of money into and out of a business. Cash flow is an important financial metric that illustrates the overall health of a business. It determines whether or not a business has enough money to pay its bills and meet obligations. When a business has a positive cash flow, it means that the company is bringing in more money than it is spending. When a business has a negative cash flow, it means the company is spending more money than it is bringing in.
In the business for sale marketplace, cash flow is used generally to describe the total amount of money a business generates for its owner(s).
Three Types of Cash Flow
There are three types of cash flow: operating cash flow, investing cash flow, and financing cash flow. Each is important to business owners and can be either positive or negative.
Operating Cash Flow
This is the amount of cash generated by a company’s normal business operations, within a specific period of time. Operating cash flow assesses how efficiently a business’ operations generate profit. The monies involved in operating cash flow are directly related to the production and sale of goods and services.
Investing Cash Flow
Cash flow from investing activities refers to the money tied to any long-term investments. Investing activities include everything from the purchase of long-term assets (such as property or equipment) to stocks and bonds, and sales or acquisitions of other businesses.
Financing Cash Flow
Cash flow from financing activities refers to the net cash linked to financing activities. Financing activities include transactions involving debt, equity, and dividends.
Cash Flow and Business Valuation
Cash flow is important when valuing a business for several reasons. Primarily, cash flow provides business owners and potential buyers with a historical metric on which to base a valuation. The going concern, or total value of a business, depends on expected future results. Cash flow allows potential buyers to have a realistic picture of the cash generated and earning potential.
For owner-operated businesses, seller’s discretionary earnings (SDE) is an adjusted cash flow metric for which sales multiples can then be applied. For example, if a business has an annual SDE of $300,000 and similar businesses trade at an SDE multiple of 3.0, an owner might expect to receive $900,000 in a sale. SDE is calculated by using the business’ net profit and then adding back specific bottom-line expenses. Some of these items include:
- Owner’s compensation
- Personal travel
- Owner's health insurance
- One-time expenses (for non-recurring expenses), like equipment upgrades
- Interest
- Amortization and depreciation
- Taxes
EBITDA, earnings before interest, taxes, depreciation, and amortization, is the primary measure of cash flow used to value mid to large-sized businesses. Businesses with EBITDA greater than $1 million use this cash flow metric, and the primary difference is that it does not include the owner’s salary as an adjustment. The choice between SDE and EBITDA largely depends on your business structure – for guidance on selecting the right metric for your situation, see our guide on valuation metrics for different business types.
How to Improve Cash Flow to Improve Business Valuation
When preparing to sell a business, improving cash flow can boost the valuation of a business. During the valuation process, potential buyers, accountants, appraisers, attorneys, and business brokers will scrutinize financial documents. There are many ways to improve cash flow and depend on the unique considerations of your business. Some of the most prominent ways are:
- Increase sales and pricing
- Reduce expenses
- Improve process of collecting receivables
- Negotiate better terms with suppliers
- Improve inventory management
- Keep reserve cash: As a general rule, three months’ worth of expenses should handle any unexpected expenses
What Is a Cash Flow Statement?
A business’ cash flow statement shows its cash flow over a period of time. It is one of the most important financial statements for both business operations and valuations because it shows how a company is managing its cash. Two other important financial statements that illustrate the financial health of a company are the balance sheet and the income statement. Cash flow statements are reported on both a quarterly and annual basis.
Cash Flow vs. Profit: What’s the Difference?
In accounting terms, cash flow and profit are often used interchangeably, but they have a clear and distinct difference. Cash flow refers to the cash or cash equivalents coming in and out of a business, while profits are the total balance when operating expenses (including non-cash expenses like depreciation) are subtracted from operating revenue. Profit can be simply calculated as the difference between the amount earned and the amount spent.
How Is Cash Flow Different from Revenue?
Revenue refers to the income earned from selling goods and services. When customers and consumers pay for goods, there are myriad methods of payment. For customers using credit, subscriptions, or making payments over time, money that has yet to be received does not represent realized cash flow.
Being able to accurately present the cash flow of a business is essential for sound accounting practices and offers an insightful view of the company's performance. Both buyers and sellers use the cash flow metric in order to value a business accurately.