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What is Discretionary Cash Flow

Written by: Don Beezley

Article Overview: The process of buying or selling a business inevitably brings up the concept of discretionary cash flow. Sometimes called owner's benefit or adjusted cash flow. It's critical for any buyer or seller of a business to understand what discretionary cash is, how it's calculated, and how it's different from profit or net income.

What is Discretionary Cash Flow

Discretionary Cash Flow Versus Profit

Discretionary Cash Flow (DCF), sometimes called Owner’s Benefit, Adjusted Cash Flow, or Discretionary Earnings, is a term that inevitably comes up during the process of buying or selling a business. Understanding what DCF is, and how it differs from “profit,” is critical to any evaluation of a business in terms of its value, and its ability to provide sufficient, post-acquisition cash flow to a buyer.

Although there are accounting technicalities when using the term “profit” versus “net income,” we’ll stick with the basic generic understanding: After subtracting your various expenses (cost of goods sold, operating expenses, etc.) from your sales, was the number left over a positive one?

What is Discretionary Cash Flow (DCF)?

The goal of a DCF analysis is to understand how much cash will be available to a new owner on an annual basis in order to: 1) pay themselves, 2) service their debt, 3) provide for any capital expenditures (asset replacement), and 4) earn a return on their investment. DCF is equal to the net income (or loss) of the business PLUS various discretionary and non-cash expenditures of the existing owner.

A typical DCF calculation might look something like this:

Net Income

+ Depreciation

+ Equipment Lease Payments (if leases are paid off at/by sale date)

+ Lease Payments on Owner’s Mercedes

+ Interest (if the debt isn’t assumed)

+ Owner’s Salary or Manager’s Salary (if the new owner will take the manager’s place)

+ Payroll taxes on Owner’s (and/or displaced manager’s) Salary

- Cost of new employee to replace one of the two former owners

- Increase in rent

= DCF

Depreciation gets added to net income because it’s not an actual cash expense in terms of writing a check. New or increased expenses, like a coming increase in rent that will affect the buyer, must be deducted from net income to reflect the new situation.

With a larger business in which you would keep or hire a new manager to run the company, owner’s compensation wouldn’t be added back. Owner’s compensation is only added back if you will be taking on that role. If the current owner’s compensation is greater than a new manager’s compensation will be, you can add back the savings on the new, less expensive employee.

This type of analysis gives you a more economic picture of the financial capacity of the business, while net income gives you a picture based on tax policies and Generally Accepted Accounting Principles (GAAP).

Analyzing Different Types of Businesses

Many businesses are quite straightforward. Some are more complicated. For example, in a ski rental business, you can’t just add back 100% of depreciation and call it a day. You have to replace about a third of your rental inventory every year. To account for that in your DCF analysis, you would add back all the depreciation, but then subtract an estimate of annual replacement costs.

Don’t confuse DCF with actual month-to-month cash flow. In the rental example, let’s say you had to pay $60k for new equipment in October, and then earn revenue over the next five months. You might have a very nice DCF over the season, but you’d better have a line of credit for the up front equipment purchases. (The nice thing in that particular industry, of course, is that ski equipment vendors extend six-month terms so you can pay for the new stuff after the season!).

Be sure to consider the nature of the business you are evaluating to ensure you calculate the DCF properly.

The Bottom Line

Net Income is an important number. It reveals information about how productive an investment is in the assets of the business. It’s also the starting point for calculating Discretionary Cash Flow, which will tell you more than Net Income about a business from the perspective of an acquisition evaluation.

The bottom line: It’s reasonable to ask if a business is profitable, but it’s more important to understand its Discretionary Cash Flow.

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