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Cash Flow Method
Buyers often look at a business and evaluate it by determining how much of a loan the cash flow will support. That is, they will look at the profits and add back to profits any expense for depreciation and amortization. They will adjust owner's salary to a fair salary or at least a marginally acceptable salary for the new owner. If the new salary is lower than the current owner's salary, the difference will be added to cash flow. If the new salary is higher than the current owner's salary, the difference will be subtracted from cash flow for valuation purposes. A person using this method may also subtract from cash flow an estimated annual amount for equipment replacement.
The adjusted cash flow number is used as a benchmark to measure the firm's ability to service debt. If the adjusted cash flow is, for example, $10,000, and prevailing interest rates are 12%, and the buyer wants to amortize the loan over 3 years, the maximum value of the firm would be about $25,300. This is the loan payment that $10,000 would support amortized over 3 years on a monthly basis.
This method is both very pragmatic from the buyer's point of view and very unfair from the seller's point of view. From the buyer's point of view, this method determines the value of the company that can be justified in terms of debt service and of eventually retiring the debt. However, a seller will argue that the business will retain its value and be saleable at the end of the amortization period. Therefore, debt service should be figured using a number closer to interest only, as is typically done in real estate analysis or in analyzing investment securities (publicly traded stocks and bonds).
Fair or not, some buyers will approach a business using this kind of formula to determine its value to them. Some buyers will use the formula but subtract the amount of cash they have available as a down payment from the loan amount, which, of course, can make a very big difference in the outcome.
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