NORMALIZED CASH FLOW - HOW IT SHOULD BE CALCULATED.
Whether preparing to buy or sell a business, understanding how to correctly calculate the Normalized Cash Flow (NCF) of a business is crucial for successful business transfers, especially in the Micro Market. To “Normalize” is the process of adjusting non-recurring, excessive or insufficient expenses and revenues.
Sellers, buyers, financiers and appraisers of businesses use this calculation to provide a reference point for future cash flow projections in order to determine a business’ ability to service acquisition debt.
NCF represents the amount of cash available to a business at the completion of a defined accounting period after paying its operating expenses, adjusting for items which are personal to the shareholders of the business, investing in its maintenance and growth and adjusting for the cash component of net working capital.
Because acquisition financing is necessary for most business transfers in the Micro Market, both business sellers and business buyers should fully grasp how to properly calculate NCF. Typically, for business buyers to satisfy an interested financier, it is necessary to calculate the previous three years annual NCF and then project monthly cash flow for the next five years.
A business’ reported earnings may be, or have been, strong and growing but not until NCF is accurately calculated can it be determined if the business generated positive cash flow in a specific reporting period.
For example, a business that reported $100,000 in annual earnings but paid $100,000 in annual capital expenditures had zero annual free cash flow. Although this business was “profitable” according to its income statement, this business had no cash available to service additional debt. Moreover, a cyclical decrease in working capital throughout the year might cause periods of negative cash flow.
As a business seller or business buyer, understanding the nuances of the Normalized Cash Flow calculation is of paramount importance.
THE COMPONENTS OF THE NORMALIZED CASH FLOW CALCULATION
The formula used by experienced business transfer professionals in the Micro Market to calculate NCF is:
EBITDA, Plus or Less adjustments to EBITDA, Less Capital Expenditures, Plus or Less change in the cash component of Net Working Capital
EBITDA is calculated based on data taken from the income statement of a business and is defined as earnings before the deduction of interest, taxes, depreciation and amortization. In the 1980s, when leveraged buyouts (LBO’s) of businesses were prevalent, EBITDA became widely used as a tool to measure a business’ cash flow and accordingly its ability to service acquisition debt. LBO sponsors pushed the concept that, because depreciation and amortization are not cash expenses, they should be considered as available cash to service debt. However, the use of EBITDA as a single measure of cash flow without consideration of other factors can be extremely misleading.
EBITDA does not account for the actual collection of cash. It is typical for a business to close the books on a year, recognize operating income, but not collect cash until a later period. Earnings (the “E” in EBITDA) are not cash. They merely reflect the difference between revenues and expenses, which are accounting concepts.
EBITDA doesn’t consider capital expense needs. Warren Buffett, in a 2002 Berkshire Hathaway shareholder letter, made the comment: “References to EBITDA make us shudder - does management think the tooth fairy pays for capital expenditures?”
Micro Market business ownership is typically a sole-proprietorship or a partnership of shareholders. Items might appear on the income statement of these businesses personal to these shareholders. These are not accounted for when EBITDA, by itself, is calculated.
EBITDA does not account for periodic changes in working capital. An increase in the average age of a business’ accounts receivable or an acceleration of payments to vendors if payment terms tighten would produce an unfavorable decrease in cash flow.
The implementation of certain accounting strategies can have a profound effect on EBITDA. For example, accounting policies that accelerate the recognition of revenues without the collection of cash makes EBITDA, by itself, an ineffective measurement of cash flow.
EBITDA is easily manipulated at year end to make cash flow appear more robust. Accelerating revenues or delaying expenses can bolster EBITDA, maybe on an unsustainable basis.
To accurately calculate NCF, other items must be considered in addition to EBITDA.
ADJUSTMENTS TO EBITDA
When buying or selling a business consider possible adjustments to the EBITDA component when calculating Normalized Cash Flow.
Because Micro Market businesses are typically controlled by a sole-proprietor or a partnership of shareholders, there may be items on the income statement which are personal to these shareholders. These items should be appropriately added back to, or removed from, the EBITDA calculation to accurately calculate the company’s Normalized Cash Flow.
The following is a list of items which could be subject to adjustment:
• Excess/Insufficient Owner Compensation. This is compensation above or below the fair market value of what a non-owner manager would be paid to operate the business. • Personal Expenses. Common expenses are automobile expenses, payroll for non-working family members, personal insurance, legal and professional fees, home utilities and personal telephone. • Travel and Entertainment Expenses. This includes travel and entertainment expenses personal to the business owner. However, if any of these expenses are deemed necessary for a new owner they should not be adjusted. • Pension Expenses. These can be an adjustment if the pension and affiliated expenses for the business owner are included on the income statement. However, only the owner’s share of the pension and expenses would qualify. • Non-Recurring Expenses. Expenses that are not a regular event in a business’ history should be adjusted to reflect comparative ongoing economic performance. For example, legal fees related to a lawsuit that is not expected to continue. • Professional Fees. This includes the cost to hire legal and financial advisors for services that would not be required after the business transfers to a new owner. • Expensing vs. Capitalizing Items. Often a business owner makes balance sheet decisions that are meant to minimize taxes rather than maximize profits. Business owners might decide to expense certain items that would otherwise be capitalized. An example of this would be an equipment purchase which is listed as an expense on the income statement when in reality it should be listed as an asset on the balance sheet. • Fair Market Rent. The owners of a business might also own the facility where the business operates. Consequently, the rent can be established at any rate. The rent should be adjusted to reflect a fair market rent if paid to an unrelated person. • Accelerating Expenses and/or Deferring Income. These are the result of implementing basic year-end tax-planning techniques that can be utilized to manage income taxes. • Severance Expenses. If there was a reorganization of the business and employees were laid off, the severance cost of these workers can be adjusted. • Percentage Of Completion Accounting. Businesses that sell services or equipment under long-term contracts might use Percentage of Completion (POC) accounting. Progress on contracts is measured by costs incurred to date compared with an estimate of total costs at the project’s completion. While these businesses may report healthy margins and generate high levels of EBITDA, they are at risk of abrupt losses at contract end resulting from an underestimation of project costs.
If necessary, funds are deployed by a business for the “maintenance” of its existing tangible assets. These funds are aptly named Maintenance Capital Expenditures. Additional funds might be earmarked to promote business “growth” and used to acquire additional assets. These funds are fittingly termed Growth Capital Expenditures.
Together these are identified on the balance sheet of a business as Capital Expenditures. These expenditures may include repairing a roof (maintenance), building a new factory (growth) or introducing a new product (growth), but don’t include expenses for day-to-day operations such as wages, advertising, insurance, etc.
When calculating Normalized Cash Flow, many don’t take into account the importance of the Capital Expenditure component. This can be a fatal mistake when selling or buying a business.
For example, the physical fitness industry generally budgets 5-7% of annual revenues for Capital Expenditures to maintain and grow an exercise facility. By deferring or reducing this expense, machinery might fail and service levels will decline. This can set in motion a vicious downward spiral as maintenance costs quickly increase and customer utilization rates decrease causing the business to fail. In this example, by delaying or reducing needed capital expense, NCF would be calculated artificially higher than it would be if the business were properly maintained.
So future Capital Expenditures can be accurately modeled, it is imperative to understand the intention of historical spending. Label each of the historical Capital Expenditures as either Maintenance or Growth and ascertain if each was effective.
Maintenance Capital Expenditures are recurring expenses which preserve efficient operations and enable the company to operate at status quo. Was the historical Maintenance Capital Expenditure sufficient to maintain the existing assets? Look for expense patterns. Are you at the top of a Capital Expenditure cycle or at the bottom? Will certain assets need replacement soon?
Once the historical Maintenance Capital Expenditure levels are understood, determine what level of expense will be needed for the future. However, due to inflation, the investment needed to maintain the same assets will generally cost more than prior expense and should be properly budgeted.
In some instances, management might choose to reduce Maintenance Capital Expenditures causing an artificial increase in the NCF calculation. However, this could lower a business’ productive capacity and efficiency, both of which are important to long-term financial health.
Growth Capital Expenditures tend to be for a one-time, specific need and are deemed necessary for the growth of a business. For example, a business operating at full capacity might have no room to grow revenues without increasing that capacity. Or a new customer might require a software upgrade before signing a purchase order. In both cases, an increase in future revenues will rely on the deployment of Growth Capital Expenditures. A carefully thought out income statement forecast can help determine future Growth Capital Expenditures.
THE CASH COMPONENT OF NET WORKING CAPITAL (NWC)
Calculated as Current Assets minus Current Liabilities, Net Working Capital is an operating metric which gauges operating liquidity available to a business at a precise point in time.
All the components of the NWC calculation are listed on a business’ balance sheet. Components of the Current Assets are Cash, Accounts Receivable, Inventory and Prepaid Expenses while elements of the Current Liabilities are Accounts Payable and Accrued Liabilities, among others. Because cash is a component of the NWC calculation, and cash levels change throughout the year, a change in the cash component of NWC will affect the Normalized Cash Flow of a business. For this reason the cash component of the NWC calculation is included in the NCF calculation.
A business may own assets and be profitable but be short of cash if Current Assets (mainly accounts receivable and inventory) cannot readily be converted into cash.
Here’s a straightforward example. Consider a business where its current assets are calculated as $100,000; composed of $50,000 accounts receivable, $25,000 inventory and $25,000 cash. Struggle to collect accounts receivable at the projected rate and the resulting components of current assets might change to $75,000 accounts receivable, $25,000 inventory and $0 cash. The total value of the current assets hasn’t changed, yet cash flow is reduced by $25,000! To offset this decrease in cash flow, management must either preserve or inject cash. Because the cash component of the NWC calculation has changed, the NCF calculation also changes.
NWC is an integral part of the value of a business. When a business is sold, it’s critical that the proper amount of NWC transfers to the new ownership.
Edward Knox is the Founder of Yarmouth Venture Group, an investment and advisory firm which guides talented individuals into business ownership. He can be reached at [redacted]