Normalized Cash Flow is first a banker’s term. They use it when they they are assessing the capacity of a firm to service debt.
More importantly, they have been using it for hundreds of years since it is the single best way to bring together all the financial rewards of owning a business.
The reason bankers use Normalized Cash Flow is to discover the continuing cash flow available to service debt regardless of the ownership structure of a firm.
Normalized cash flow times their bank’s current lending multiple lets the banker tell the lender how much he can borrow.
A single practitioner, a sole proprietorship, a private company, a big multi-national all have different tax rules to live by so different needs in presenting earnings numbers. But all can be easily compared with each other by a banker after he normalizes the cash flow.
Buyers and sellers want the same numbers.
Why? If you think about it, bankers are the only ‘numbers’ people who stick their neck out. Accountants, lawyers, brokers, etc give opinions. Only a banker has ‘skin in the game’.
If a banker lends more money than prudent, then his neck is on the line. But if he doesn’t loan enough, then his customer will bank elsewhere.
Banker’s have had several centuries of modern commerce to learn what works and what doesn’t. Like Goldilocks, they know what’s ‘just right’.
That’s why from Wall Street to a suburban Alberta office suite, the wise listen to the banker’s numbers even when they don’t like them.
Banker’s numbers also work for business buyers and sellers as the common denominator to show the rewards of ownership for any type of corporate structure.
NCF strips away the artifacts introduced by the organization of the firm, the tax situation of the ownership (and the rewards of ownership) plus other variables that stem from sources other than the firm’s operations. (On US websites, you will often see a very similar number called Seller’s Discretionary Cash Flow.)
This is why experienced business brokers use NCF as the best way anyone has yet come up with to compare the rewards of ownership regardless of the type of business or the way it is set up.
It’s much like a handicap for golfers or total points for a hockey player.
Brokers use the same normalized cash flow number as the banker but with a different multiple as a guide when pricing a business.
And Buyers will often use normalized cash flow numbers as the base for a pro-forma to speculate how the numbers would differ if they were running the firm.
NCF is always based on actual historical numbers. When there is a change ownership, differing circumstances may change the future finances of the firm. But those changes will be reflected in a pro-forma numbers, not in the normalized cash flow numbers, until they become historical.
The process to discover normalized cash flow is simple. Start with the earnings statement from the firm’s outside tax accountant or their completed and submitted tax form.
Think of net earnings as the entry showing the dollar amount to be shared between ownership and the tax man.
A banker or broker will take that number and add back certain expenses. This means normalized cash flow should always be the same or higher than net earnings.
The expenses that are added back are limited to:
Owner benefits (wages, golf course membership etc). This removes the differences to net earnings caused, as a common example, one owner taking a salary while another owner lives off dividends.
Ownership expenses (interest, charitable donations etc). This removes the differences in the accountant’s net earnings caused by the personal financial circumstances of the owners. We just want to see numbers based on the historical operations of the firm.
Extra-ordinary expenses or one-off’s (moving to a new location, hiring a lawyer to sue a bad debt). This removes expenses that are not expected to repeat.
Non-cash items (amortization or depreciation). This removes expenses charged to net earnings that were not real cash disbursements in the period covered. (They are a tax recovery of ‘sunk money’ reflecting cash that was spent in the past but not expensed. This is usually because of tax rules insisting that certain types of cash outflows be treated as capital expenditures instead of expenses that can be written off in the current year).
Once we have a normalized cash flow number buyers can use it to compare and assess the values of different firms or to build a Pro Forma to plan future operations.
Caution: Sometimes you will see EBITDA used. EBITDA implies professional management so the owner’s benefits are not added back.
Professional management brings greater comfort since it will be continuing under the new ownership. And greater comfort merits a higher multiple.
So sometimes you see the rewards of owner operated firms expressed as EBITDA and priced at the higher EBITDA multiple.
Run if you come across this. Either the seller does not understand the term or worse, does knows it brings a higher multiple and hopes you don’t know the difference.
But in either case, your leg is being pulled.