Understanding Discretionary Cash Flow

Known by different names (discretionary income, discretionary earnings), the seller’s discretionary cash flow is a particular marker of profitability that lets you and others know more about the valuation of your company. Many buyers will ask about this metric when buying a company to learn about the typical amount of profit available to be used at the discretion of the owner. Essentially, the discretionary income can be thought of as net profits plus non-routine expenses paid out. 

Which Expenses are Added to Figure Discretionary Cash Flow?

The discretionary income is always calculated without regard for the eventual tax liability, known simply as pre-tax earnings. Also added to the discretionary income are one-time expenses, such as renovating the company headquarters or big one time legal bills and any owner benefits that are paid by the company. Other expenses that are considered routine but not part of operating, like depreciation and amortization (theoretical expenses), are added. Simply put, most non-operating and non-recurring expenses are added to the company’s net profit to come up with the discretionary income. 

Which Expenses are Excluded from Discretionary Cash Flow?

Employee wages, monthly rent for headquarters, payments to vendors or wholesalers, and other routine, expected expenses are not added to the net profit in figuring discretionary earnings (because these are expenses that must be incurred to generate the revenue for the business). These are expenses that the owner of a company has no choice but to pay. The pre-tax earnings of the owner-operator are added to the discretionary income, as the owner-operator determines his or her own income. 

Seller’s Discretionary Cash Flow in Business Transactions

Knowing the discretionary cash flow is certainly useful, but buyers might be looking for a different amount of involvement in a company than its original owner. Therefore, the discretionary income that the seller of the business presents may not be completely applicable to the valuation considered by the buyer. Non-operating business revenue is not usually added to the net profit in order to find out the discretionary cash flow, but some sellers might add it to improve the business’s valuation. Because most business transactions involve a buyer that is most interested in buying a consistent, dependable recurring revenue stream, discretionary cash flow is usually the key component of how a buyer will price a business.

Conclusion

Buying a business, or selling the one you’ve poured countless hours of hard work into, is not a simple process. It can be easy to lose sight of the main goal: getting the best value during the transaction. Our simple process of improving the Eight Drivers of Business Value is specifically designed to help you increase the value of your business by focusing on the key factors that influence how attractive your business will be to a prospective buyer.  

If you have questions about calculating your business’s discretionary income, want a valuation of your business or would like to get to work improving its value, please reach out to us today. 

The following two tabs change content below.

Soterian

At Soterian, our goal is to help business owners like you think bigger. Bigger than today, bigger than your business, bigger than yourself.

Latest posts by Soterian (see all)

%d bloggers like this: