Owner's Cash Flow - The Best Measure of the Earning Power of a Small BusinessWhen buyers look at how much they can earn from a small business, they are interested in the total income available to them. In general, the reported earnings of small businesses are purposely kept low. This is because these earnings are reported for tax purposes and owners want to keep their taxes low. Therefore, we use Owner's Cash Flow, or Seller's Discretionary Earnings, as a better measure of the earnings of a small business than the reported income. It is defined as net income before deducting the primary owner's compensation and benefits, other discretionary, non-operating, or non-recurring income or expense, depreciation, interest, and taxes.
When valuing a business, we need to recast the earnings in order to show a potential buyer what the owner actually earns from the business. Interest expense is added back because the buyer is generally not assuming the debt of the business. Depreciation and amortization are added back because they are not cash expenses. However, if it is necessary to replace equipment within the next year, we deduct the expected expense. Taxes are added back because a new owner may have a different tax expense.
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