HOUSTON BUSINESS REVIEW

TUTORIAL ON SELLING YOUR BUSINESS "Enhancing Value – Financial Perspective Part VI"
By Ralph Fain

Ralph Fain is a principal in the brokerage firm, R/Fain Group. Mr. Fain also has over 20 years of broad business experience with Fortune 500 companies. R/ Fain Group is a professional business brokerage firm which confidentially represents the interests of various sellers and buyers. Each week Mr. Fain will give tips on Business Brokering, and how to sell your business.

In our last article, we discussed the need for proper coding/classification of accounting and financial transactions and the need for legal and transparent tax strategies. We also briefly reviewed the definition of cash flow and defined and gave examples of “add-backs”. Today’s article will demonstrate the importance of variance analysis, the importance of proper accounting classification and the importance of “add-backs” in the valuation of a company.

In past articles, we had defined discretionary cash flow (for our purposes) as net income (profit/earnings) plus “add-backs” for depreciation, amortization, owner’s/family’s salaries/benefits (particularly any excessive amounts but in some cases the entire amounts), owner’s/family’s prerequisites (“perks”), significant one-time expenses, and, in certain cases interest charges.

“Adding-back” the above described items to Net Income allows one to arrive at a figure generally regarded as gross cash flow (i.e., Net Income plus “add-backs”). From this figure, you would want to deduct the cost of reasonable salary/benefits for someone to operate/manage the business (whether this is the buyer or someone else designated by the buyer) – the resultant figure roughly approximates net cash flow (or cash flow before debt service). Finally, from this figure, you would want to deduct the cost of debt service (amount of principal and interest paid on a note financing the purchase of the business) – this gets you to what is commonly referred to as cash flow after debt service (net net cash flow). [Note: the above definitions of cash flow are generic in nature and are intended only to provide the reader a fundamental mechanism for his/her utilization. The definitions above are not intended to be identical to the theoretical accounting definition of cash flow.]

As you may recall from recent articles, we had performed variance analysis for a company’s financial statements for the years 2002-2004. The results of that analysis led us to restate the 2004 financial statement due to improper accounting classification/coding errors of certain expenditures during the year 2004; one of the accounting errors was $150,000 in capital expenditures being inadvertently expensed instead of capitalized (as additions to assets). This error caused the company’s Net Income to be understated (too low) for the year ; correction of the error allowed us to more accurately reflect the company’s financial results for that year and resulted in an $150,000 increase to Net Income.

Additionally, consider the following scenario: Our company has a net income (per original 2004 year end financial statement) of $18,000; during 2004, owner was paid salary/benefits of $175,000 and several family members were employed in the business with collective salaries/benefits of $200,000 (a new owner/buyer could replace these family members, including you (the current owner), with new employees for $180,000 in salaries/benefits); depreciation for the year was $35,000 and one–time moving expenses of $40,000 were incurred; interest of $20,000 was paid on a business note during the year (a buyer’s principal/interest payments on a business note to purchase the company will average $50,000/yr; and owner’s “perks” for 2004 were determined to be $15,000 (new owner/buyer will have no “perks”). With these facts and the above noted adjustment in mind, please note below what happens to the calculation of cash flow:

		Net Income as originally shown per 2004 Financials		$ 18,000
		Adjustments due to accounting errors					   $150.000
 
		Net income as restated (prior to add-backs)				$168,000			
		Add- backs
			Owner’s salary/benefits			        $175,000
			Family’s salaries/benefits			$200,000
			Replacement ees’ salaries/benefits	(180,000)		
			Depreciation				     	            $35,000
			One-time moving expense			      $40,000
			Owner’s “perks”					         $15,000
			Interest					   	         $20,000
				Net “add-backs”				      $305,000					
Net cash flow								        $405,000

		Other adjustments
			Debt service of new owner/buyer			(50,000)

		Cash flow to owner after debt service ( net net cash flow)