Comprehensive Explanation of Cash Flow Calculations from a SBA Lender’s Perspective

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

When acquiring a business, an entrepreneur must assess whether the business generates sufficient cash flow to support both the acquisition and ongoing financial obligations. Determining “sufficient” cash flow is complex, considering factors such as financing requirements. If SBA financing is involved, the business must generate enough cash flow not only to service debt but also meet the buyer’s personal financial needs.

Accurately determining a business’s cash flow can be challenging, especially in small businesses where personal and business expenses are often commingled. Cash flow calculation varies among buyers, sellers, and lenders, and understanding each party’s evaluation criteria is crucial. Notably, when SBA financing is involved, the buyer should comprehend what lenders include and exclude in their cash flow analysis.

Non-cash expenses, such as depreciation and amortization, are deductions allowed but do not represent actual cash outlays. They can be added back to available cash flow.

Interest expense is generally incurred by sellers when purchasing assets free of debt. As a result, any interest expense the seller incurs is not an expense of the buyer and can be added back. However, interest on new financing used by the buyer to complete the acquisition will be factored into debt service coverage calculations.

One-time expenses are costs that do not recur annually. They may include items such as consulting services for a completed project, increased professional fees due to a singular event, major repairs not capitalized on the balance sheet, and others. Since these expenses are not anticipated to recur, they can be added back to the available cash flow.

Discretionary expenses encompass business expenses such as donations, meals and entertainment, and travel. Generally, these items are insignificant and are included in all business financial statements. Consequently, a lender is less likely to account for them in its analysis. However, if these categories represent substantial expenses, the lender may consider them if there is a satisfactory explanation of 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 are typically viewed as items a seller has expensed for personal use only and would not represent an expense of a buyer. These expenses may include the seller’s personal salary, as well as such items as auto expenses for a personal vehicle, personal travel expenses, personal cell phone and utility bills, personal medical and life insurance, and others. Additionally, the seller may be paying a salary to a family member who does not contribute significantly to the business.

A lender will add back the seller’s personal salary and the salaries of family members who are not actively involved in the business provided there are W-2 forms and paystubs to support the add backs. A lender may also 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 buyer’s would be and can be documented as such.

Regarding other personal expenses, it becomes a question of whether they are material and can be documented. Generally, they would not be considered by the lender.

Adjustments to Decrease Cash Flow

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 on both industry averages and the personal income needs of the buyer. Additionally, if the buyer intends to hire an additional manager or other employee, adjustments for these proposed wages must also be considered.

Non-Recurring Income:

Non-recurring income refers to income that is not typically earned year after year. Examples include insurance claims or gains from the sale of assets. Additionally, recent items such as Paycheck Protection Program (PPP) loan proceeds, debt forgiveness, or ERTC credits are considered non-recurring and would be deducted from a business’s cash flow if applicable.

Capital Expenditures:

While depreciation expense is added back, capital expenditures represent capital assets or improvements on the balance sheet that have been acquired or completed. These assets often require replacement or incur higher maintenance costs in a particular year. For instance, businesses that need substantial equipment or vehicles may face capital expenditures. In such cases, the lender may include a capital expenditure adjustment to account for the recurring cash outlay.

It is important to note that this is not an exhaustive list of potential adjustments. However, it provides a general understanding of how lenders may assess cash flow. Ultimately, if a business is attempting to manipulate cash flow or lacks documentation for add-backs, it may not be a suitable candidate for lender financing. Conversely, if an adjustment is substantial, logical, and can be substantiated, the lender is more likely to consider it.

For those seeking to acquire a business, it is highly recommended to collaborate with an experienced Small Business Administration (SBA) lender or other financial professional. These experts can provide guidance on structuring the cash flow analysis in a manner that aligns with lender expectations and maximizes the chances of securing favorable financing.

When acquiring a business, an entrepreneur must assess whether the business generates sufficient cash flow to support both the acquisition and ongoing financial obligations. Determining “sufficient” cash flow is complex, considering factors such as financing requirements. If financing is involved, the business must generate enough cash flow not only to service debt but also meet the buyer’s personal financial needs.

If you have any questions about the topics mentioned or anything else related to buying or selling food and beverage businesses, feel free to reach out to me at 949-237-2824 or michael@restaurantrealty.com.