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Jeff Slaton - How is Owner's Discretionary Cash Flow Calculated? (ODCF)
How is Owners Discretionary Cash Flow Calculated? (ODCF) There is a great deal of confusion concerning the calculation and significance of ODCF. Jeff Slaton offers a few helpful guidelines ... .
By: Jeff Slaton NetWorth Business Brokers
There is a great deal of confusion concerning the calculation and significance of ODCF. First, 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, you 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”
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 over staffing, 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 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 10 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.
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NetWorth Business Brokers is a company of people who believe all independent business owners have the right to a fair price when they sell their company, or to follow a strategy that will create the highest value during their ownership.
Jeff Slaton is with http://www.NetWorthBusinessBrokers.com belongs to one of the nation's largest networks of business consultants. Jeff has been working closely with business owners for more than 10 years, ensuring their sales, marketing, financial, and exit objectives are successfully executed. NetWorth Business Brokers delivers face-to-face business consulting to small business owners seeking a future exit from their companies. He can be reached at Broker@NetWorthBB.com or 612-419-2905 for more information.
Page Updated Last on: Jul 09, 2009