We've seen on the broker sites a business listed, they are asking for $1.2M and their "Cash Flow" is $500k.

Now the question is, how did they calculate that "Cash Flow".

Most brokers base themselves on Rule Of Thumbs. In finance, there is no Rule Of Thumbs. Unless you want to overpay of course.

The usual rule of thumbs are: EBITDA and Industry Standard Multiples, the biggest problem with those two metrics is that they don't take into account the financial structure of a business.

We see the cash flow stated on the P&L but we usually don't account for the risk associated with that cash flow, meaning where is the money coming from? Contracts? Walk In Customers? Word of Mouth?

You see, the less diversified a business is the more risk is associated with it, this is why I stay away from Product Based Businesses, anybody can provide a better product for a cheaper price and you are out of the market, instead I focus on Service Based Businesses, these are services that are needed and we can provide, thus overhead is low because there is no product manufacturing for the most part, then we have to account for our customer base and cash flow generation.

For example, the business is producing $500K, but there is a contract set to expire this year that accounts for $200k of that $500k, now the question is, can we renew this contract? If not, we would have to deduct it as this cash flow will be nonexistent in the years to come.

You can argue that this is the information that will be analyzed during due diligence, but if you agree to a price and then come back and try to drop it by 40-60% after you find some skeletons in the closet, the seller and or broker won't be very happy.

This is why it's important to factor in these items from the start and incorporate them into your negotiations.

Always analyze where the cash flow is coming from and how stable is that source.