Historically, there has been a great deal of confusion concerning the calculation and significance of ODCF. First, understand that it is not taxable income as shown on the tax return. Second, it is not net income as shown on the income statement. Rather, it is a calculated figure that helps a buyer determine how much free cash flow is available to a new owner if he or she buys the business in question.
To perform the calculation correctly, please do the following:
1. Start with either taxable income from the tax return or net income or net loss from the income statement.
2. Then, add back owner’s compensation and owner’s payroll taxes.
3. Next, add back any owner perks such as medical insurance, life insurance (usually non-deductible for tax purposes), automobile expenses, cell phone expense, pension-related expenses (can be Keogh, 401k, SEP-IRA, etc.), dues and subscriptions (if applicable), etc.
4. Then, add back amortization expense and depreciation expense, since they are “non-cash” items and simply serve to reduce taxable income (net income) so that less tax can be paid legitimately. If a company is capital intensive with significant fixed assets (machinery and equipment), you may not be able to add back 100% of the depreciation expense.
5. Next, you add back interest expense if it is unrelated to net operating leases that are expensed properly on a monthly basis and have no buyback provision at the end of the lease. The reason for adding back interest expense is because a new owner will have his or her own debt structure with the associated interest expense having no relationship to what the current owner is paying.
6. Then, you will add back any one-time, non-recurring expenses. Examples can include a major software upgrade, litigation expenses, major repairs and maintenance, consulting expenses or anything else that is not going to affect the new owner.
7. Then you will make employee-related adjustments for family members who do not work in the business but are being paid by the business. This also applies if a family member works in the business, but receives more or less than market wages. Thus, the adjustments can be positive add-backs or negative add-backs. If another non-family member is either overpaid or underpaid, a similar calculation must be made.
8. If a 2nd working owner will be leaving the company along with the 1st working owner and the buyer does not have a spouse or partner to replace the individual, then there must be a negative add-back for a replacement employee at a market rate of pay.
9. Now, we get into a truly gray area… Sometimes a business owner uses a company check to pay for a personal item or totally non-related item that has nothing to do with the business. This check is then coded to a general ledger account like cost of goods sold or some other expense account. These items are also add-backs, but the business owner feels awkward disclosing them because they cannot be justified. Yet, sometimes, the cumulative amounts are quite significant and not adding them back severely understates ODCF.
10. And, last but not least, we arrive at unreported cash sales or “skim” as they are commonly known. Under normal circumstances, skim cannot be adequately proven, and as a result, these sales cannot be added back. But in rare instances, skim can be proven and can be treated as a legitimate add-back. Obviously, this is the most sensitive area of all, since the business owner is doing something illegal for which the penalties can be quite severe. Many business owners will simply not disclose their skim and understand they will receive less for their business as a result of not depositing all sales into their checking account.
Author’s note: After helping sellers and buyers for more than 20 years, I have found that honesty, integrity, full disclosure, patience and a willingness to consider various alternatives makes the probability of success for all parties very high.
Loren Marc Schmerler, CPC, APC is the former business advice columnist for Sam's Club. He has been a business broker since 1986 and works with business owners and business buyers in every state of the country. If you need assistance selling or buying a business anywhere in the United States, you can reach Loren at 404-550-1417, 24/7/365.
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