How to Value A Business Based on Free Cash Flow

What is Free Cash Flow?

When it comes to selling a business, free cash flow is a very useful metric when determining the value of the business. Free cash flow is traditionally defined as a measure of profitability that begins with a company’s ordinary net income (or taxable net income) and then excludes non-cash expenses on the income statement (such as depreciation) and includes capital expenditures or changes in working capital (both of which are not on the ordinary income statement).

Difference Between Free Cash Flow and Ordinary Net Income

  • Ordinary net income – such as the taxable net income represented on a tax return – is a measure of profitability that deducts non-cash expenses such as depreciation.
  • Additionally, ordinary net income does not deduct capital expenditures such as expenses on property, plant, or equipment that are used over multiple years.
  • Nor does ordinary income deduct changes in working capital on the balance sheet.
  • Working capital is simply the difference between a company’s current assets (such as cash or inventory) and current liabilities (such as accounts payable or debts).
  • Free cash flow may be calculated by starting with the company’s ordinary net income, and then adjusting for its capital expenditures, working capital, and depreciation.
  • As an evaluation tool for small businesses, free cash flow is useful as it determines how much cash the business has actually taken in (or lost) over a set time period.

Difference Between Free Cash Flow and EBITDA

The EBITDA of a business refers to Earnings Before Interest, Taxes, Depreciation, and Amortization (as a side note, the reader should be aware that small business valuations always look at the company’s pre-tax profits no matter the metric used). For small businesses, the main difference between EBITDA and free cash flow is that EBITDA does not factor in capital expenditures or changes in working capital. Both EBIDTA and free cash flow exclude depreciation (a non-cash charge). Free cash flow typically (but not always) excludes debt service (or amortization) and interest payments on business debt.

When Interest and Amortization Are Excluded from Free Cash Flow

For small business sales, it is appropriate to exclude interest and amortization expense from free cash flow when the debt of the business is not transferable to the buyer. If the business debt is to be assumed by the buyer, then the interest or payments on the assumed debt should be deducted from free cash flow. Importantly, EBITDA does not deduct anything for changes to working capital or capital expenditures. For this reason, many buyers of businesses prefer to focus on free cash flow.

Difference Between Free Cash Flow and Owner Benefit

A company’s adjusted owner benefit or true economic profits derived by the owner of the business, is the most widely used metric in business sales. The adjusted owner benefit takes the EBITDA and then adds back other costs of the business that actually give economic benefit to the owner. These include the owner’s salary (and the salaries of family members of the owner minus their replacement costs), unrecorded cash sales, and expenses that are used as business deductions but in reality are personal expenses of the owner (such as the owner expensing their personal vehicle through the business). Unlike free cash flow, however, an owner benefit analysis does not deduct capital expenditures or changes in working capital. For businesses that face frequent capital expenditure charges or significant changes in working capital, it is always best to factor in these charges when determining the valuation of the business.

Example of Using Free Cash Flow in Business Valuation

  • Let us suppose that Greg wishes to sell his gutter company (Greg’s Gutter Company) and receives a business evaluation from a professional business broker.
  • The business broker sees that the 2021 taxable net income is $300,000.
  • Looking more closely at the financials, the business broker discovers that the business expensed $50,000 for depreciation, the owner paid himself a $100,000 salary, and the owner expensed another $100,000 of personal expenses through the business.
  • The adjusted owner benefit of the business is thus $550,000 as all of those ‘expense’ items were actually benefitting the owner.
  • The free cash flow is $350,000 as the depreciation is not counted as it is a non-cash expense.
  • Note that the free cash flow does not incorporate the owner’s salary or the owner’s personal expenses that were expensed through the business.
  • Let us now suppose that in 2021, the business purchased a gutter truck for $200,000 (in cash with no financing).
  • The useful life of the truck will be for many years in the business and is, therefore, a capital expenditure.
  • The capital expenditure for the truck ($200,000) would not all be deducted in 2021 (for tax purposes), but would have a depreciation schedule that allows the business to deduct the $200,000 over a number of years.
  • When calculating the 2021 free cash flow of Greg’s Gutter’s Company, one takes the ordinary net income of $300,000, deducts the capital expenditure charge of $200,000, and adds back the $50,000 depreciation charge to equal only $150,000.
  • This then would lead to a much lower valuation for Greg’s business.
  • In reality, Greg will not agree to this lower valuation because the purchase of the gutter truck was not a regular business expense and will provide value to the business over many years.
  • Thus, a fairer valuation method in this instance is to estimate and deduct from the adjusted owner benefit the ‘normalized’ amount of capital expenditures that Greg’s Gutter Company will face in an average year.
  • The business broker determines that Greg needs to purchase a new gutter truck (worth $200,000) every four years in order to meet the growing demand for his business.
  • Greg will then face an average of $50,000 per year ($200,000/4) in capital expenditures.
  • Greg’s normalized free cash flow is, therefore, $300,000 to account for the normalized amount of cap ex the business faces.
  • The adjusted owner benefit, in this instance, should also account for the normalized amount of cap ex ($50,000) and be reduced from $550K to $500K.

What is Free Cash Flow Yield?

Free cash flow yield is simply the current annual free cash flow divided by the purchase price for the business. Importantly, if the business debt is to be assumed by the buyer, then the debt must be added to the purchase price of the business. If, for example, the purchase price of a business is $250,000 and the business debt to be assumed by the buyer is $100,000, then $350,000 is used as the denominator when calculating the free cash flow yield. With a free cash flow of $70,000, the free cash flow yield in this example is 20% ($70,000/$350,000).

Determining the free cash flow of a business is a very useful metric for business valuations, and every business seller should consult a professional business broker in order to determine their free cash flow before selling their business.

Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.