IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses.  The following blog has been provided by Jennifer Ringenbach of KeyBank (https://www.key.com/small-business/banking/loans-lines/sba-loans.html):

Cash Flow Calculations Explained from a SBA Lender Perspective

Acquiring a business is an exciting event for an entrepreneur working toward fulfilling his or her dreams.

When acquiring a business, one of the most important factors an entrepreneur must assess is whether the business generates sufficient cash flow to support both the acquisition and the ongoing financial obligations of the buyer. Determining what constitutes “sufficient” cash flow can be complex, as it depends on several variables, including whether financing is required to complete the transaction. If financing is involved, the business must generate enough cash flow not only to service the debt but also to meet the personal financial needs of the buyer.

Determining the accurate cash flow of a business can be challenging, especially in small businesses where personal and business expenses are often commingled. The way in which cash flow is calculated will vary between buyers, sellers, and lenders, and it is essential to understand the specific criteria that each party considers when evaluating financial health. Particularly when financing is involved, it is crucial for the buyer to understand what lenders will include in their cash flow analysis—and what they will exclude.

Non-Cash Expenses.  Non-cash expenses such as Depreciation and Amortization, are deductions that are allowed, but do not represent actual outlays of cash and therefore can be added back to the available cash flow.

Interest Expense.  Generally, a buyer purchases the assets of a business free of any debt.  As a result, any interest expense the seller has incurred would not be an expense of the buyer and therefore can be added back.  However, it is important to note that the interest on any new financing used by the buyer to complete the acquisition will be factored into the buyer’s debt service coverage calculations.

One-Time Expenses.  These represent costs that generally do not recur year over year.  They may include such items as a consultant hired for a specific project that is now complete; higher professional fees due to a singular event; a major repair that was not capitalized on the balance sheet; as well as others. Since these expenses are not expected to recur, we can add them back to the available cash flow.

Discretionary Expenses.  These consist of such business expenses as donations, meals & entertainment, and travel.  Generally, these items are negligible and show up on all business financials, so a lender is less likely to account for them in its analysis.  If these categories represent significant expenses, however, the lender may consider them if there is a satisfactory explanation of exactly why a new buyer should not expect to incur these expenses; and if they can document the specific add back, particularly if it is only a portion of the amount for that line item.

Personal Expenses.  These are typically viewed as items a seller has expensed that have been for his or her personal use only and would not represent an expense of a buyer.  Along with the seller’s personal salary, it also may include such items as auto expenses for a personal vehicle, personal travel expenses, personal cell phone and utility bills, personal medical and life insurance, along with others.  In addition, the seller may be paying a salary to a family member who does not contribute in any significant way to the business.   A lender will add back the seller’s personal salary as well as the salaries of family members who are not active in the business provided there are W2s and paystubs to support the add backs.  A lender may add back the seller’s medical insurance costs if the buyer has another source for that insurance coverage such as a spouse or may add back a portion of the expense if there is a specific reason a seller’s medical costs were higher than a buyers would be and can be documented as such.  As far as the other personal expenses, it becomes a question as to whether they are material and can be documented, but as a rule, they would not be considered by the lender.

In addition to add backs that increase cash flow, there are also adjustments that may decrease it.  These often include:

Buyer Compensation. While we will add back the salary that a seller has taken, we must then account for a salary for the new buyer.  The amount of this deduction will depend both on industry averages as well as on the personal income needs of the buyer.  In addition, If the buyer intends to hire an additional manager or other employee, adjustments for these proposed wages must also be considered.

Non-Recurring Income.  This is income that is not generally earned year after year.  Income from an insurance claim or a gain from a sale of an asset would typically be non-recurring income. In addition, such recent items as Paycheck Protection Program (PPP) loan proceeds, Debt Forgiveness, or ERTC credits, are considered non-recurring and would be deducted from the cash flow of a business if applicable.

Capital Expenditures.  While depreciation expense is added back, this figure represents capital assets or improvements on the balance sheet that have been acquired or completed.  Oftentimes, these assets must be replaced or may incur higher than usual maintenance costs in a particular year. For example, this may include a business that has need for a large amount of equipment or vehicles.   If this is the case, the Lender may include a Capital Expenditure adjustment to account for the recurring cash outlay.

This is not, by any means, a complete list of all the potential adjustments, however, it should provide a better understanding of how a lender may look at the cash flow.  Bottom line, if you are “nickel and diming” to make the cash flow work, or cannot document the add backs, then it is likely not going to be a good fit for lender financing.  However, if an adjustment is material, makes sense, and can be documented, the lender is more likely to consider it.

For those seeking to acquire a business, it is highly advisable to work with an experienced SBA lender or other financial professional. These experts can provide guidance on structuring the cash flow analysis in a way that aligns with lender expectations and maximizes the chance of securing favorable financing.

Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. Content provided for informational and educational purposes only and is in no way to be construed as financial, investment, or legal advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal financial issues. KeyBank does not provide legal advice. KeyBank Member FDIC. KeyCorp. © 2024.         CFMA #241115-2893628

Investment products are:  NOT FDIC INSURED* NOT BANK GUARANTEED* MAY LOSE VALUE * NOT A DEPOSIT* NOT INSURED BY ANY STATE OR FEDERAL AGENCY

If you have questions relating to the content of this article, Jennifer Ringenbach, a KeyBank Senior SBA Sales Representative, would welcome inquiries. Jennifer can be reached at (253) 305-7588 and Jennifer_ringenbach@keybank.com.

 IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.