Cash Flow Add Backs: Everything You Need to Know
Cash flow add backs are completed to account for adjustments that were made in calculating the business net income based on the accrual method of accounting. 3 min read
2. Purpose of Add Backs When Selling a Business
3. What Are the Different Kinds of Add Backs and Adjustments
Cash flow add backs are completed to account for adjustments that were made in calculating the net income of the business based on the accrual method of accounting. Net income is determined by adding or subtracting differences in expenses, revenue, and credit transactions. These adjustments are performed to account for the non-cash items that were included in the net income of the business. The reason that there is a difference between cash and income is because the accrual basis of accounting treats sales as profit and expenses as losses, even though the revenues from the sale may not have actually been collected and expenses may not have yet been paid.
What Are Add Backs
Cash flow add backs relate to expenses that will not be included in the prospective buyer's future income statement. The expenses will be added back to the profits of the organization for the purpose of improving the financial appearance of the business. Applying and understanding add backs and adjustments helps in managing an organization's earnings on a quarterly basis. After completing the add backs and adjustments, a true illustration of the amount of cash flow that the organization is generating should be revealed. In other words, you'll be able to see the true value of the business.
Add backs may massively influence the valuation of the company because a multiple is going to be attached to the final owner benefit's number to calculate a recommended purchase price. For example, if a four times multiple is adopted, a $100,000 add back will equal a $400,000 increase in valuation. "Owner's benefit" may also be known as:
- Adjusted cash flow
- Seller's discretionary earnings
- Seller's cash flow
Remember the following points when working with add backs:
- When calculating the owner's benefit, only expenses may be added back
- When including personal seller expenses as add backs, verify that they're truly personal and not expenses the new owner will need to pay
- Watch out for one-time expenses that a seller may attempt to sneak into the calculation as an add back
The formula used to calculate the owner's benefit is: Owner's Salary + Pre-Tax Profit + Additional Owner Perks + Depreciation LESS Allowance for Capital Expenditures + Interest
One of the most critical aspects of purchasing a business is calculating the correct owner's benefit. Individuals looking to calculate the number themselves must be prepared to be extremely diligent. Also, the purchaser should be extremely aware as to how the owner's benefit was created should they need to openly debate the figures.
Purpose of Add Backs When Selling a Business
A substantial number of add backs will increase the company's profits on an adjusted or normalized basis. The value of the business will be increased when a multiple is utilized. Remember that the intention for using add backs isn't to increase the value of the business. Instead, it's intended to display the correct historical cash flow statement to a prospective buyer.
What Are the Different Kinds of Add Backs and Adjustments
The financial transactions of the business will need to be analyzed in order to identify potential add backs and adjustments. Positive add backs will include:
- Owner compensation: The difference between the current compensation rate and the market rate
- Personal and benefits expenses: Includes benefits that will not be granted going forward
- Market value adjustments: The difference between a normalized expense and one that is under or over market value
- Inventory adjustments: May include adjustments between FIFO and LIFO
- Taxes and benefits: If including add backs for any adjustments to owner's compensation, it's important to add back the interrelated taxes
- Lawsuit and severance settlements: As long as these expenses are unusual or rare, they may be added back
- Personal expenses: The owner's personal expenses may also be added back
While add backs are an ongoing historical expense, positive adjustments are one-time occurrence. Positive adjustments are expenses that were incurred once, in a prior year but will never happen again and may include:
- One-time professional fees
- Disaster expenses
- Lawsuit expenses
- Startup costs
Remember if a one-time expense hits the organization's income statement across numerous years, than it's not a one-time expense. Instead, it's a recurring expense and not eligible to be included as an add back expense.
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