Cash is King For Operations and Succession
For small business owners planning to step away from operations, cash flow analysis is a fundamental component of succession planning. By understanding and optimizing cash flow, business owners ensure that the company remains financially healthy throughout the transition period, which can make a significant impact on the long-term success of the business and the financial benefits of the transition. Here’s a closer look at why cash flow analysis matters, how to perform it, and ways to use cash flow data for effective succession planning.
Why Cash Flow Analysis Matters in Succession Planning
Cash flow analysis reveals how money moves in and out of a business over a specific time period, which is crucial for assessing the overall financial health of the business. Unlike net income, which is an accounting measure of financial performance, cash flow provides visibility into the actual level of cash that moves in and out of a business. Cash from operations can be used to invest in the business, pay debt, or pay dividends to equity holders.
For a business owner preparing to transition out of the operations, understanding cash flow can:
Inform a new owner regarding the ability of the business to fund operations, growth, and to cover the cost of equity or debt capital used to finance an acquisition
Ensure valuation accuracy by providing a clear view of cash provided by operations, as well as clarity regarding the nature of revenue (project based or recurring)
Identify risks and financial gaps that may threaten the transition or put strain on incoming owners, managers, or family successors.
Cash flow is particularly important for small businesses where cash-on-hand and liquidity are limited. Prospective buyers or successors look for stable and predictable cash flow as a positive sign for investment. For family businesses, cash flow stability is often a prerequisite for future planning and growth by the next generation.
Steps to Performing Cash Flow Analysis for Succession
Performing a thorough cash flow analysis is a multi-step process that can feel daunting to owners who lack finance or accounting backgrounds. Businesses without an internal finance or accounting team member can lean on third-party firms, such as CPA firms, for guidance. Here are the fundamental steps a business owner should take:
1. Gather Financial Statements and Historical Data: Start by reviewing the business’s recent financial statements, ideally covering the past three to five years. Key documents include cash flow statements, income statements, and balance sheets. What trends are present in the data? Take note of year-over-year changes to revenue growth, cost of goods, and operating expenses. Consider seasonality and how this may impact cash flow timing.
2. Break Down Inflows and Outflows: Separate your cash inflows (like sales revenue, interest, and investments) from cash outflows (such as payroll, rent, utilities, and loan repayments). Although this seems like a straightforward task, if a company has non-cash expenses, such as depreciation, or if working capital creates cash collection delays, then it’s important to consider proper adjustments to capture an accurate measure of cash flow. This breakdown helps pinpoint areas where cash is spent, especially recurring costs or capital expenditures that may impact future cash flow.
3. Identify Non-Recurring Cash Flows: Often, one-off sales, asset sales, or legal settlements may appear on financial statements but aren’t part of regular operations. Removing these non-recurring transactions gives a more accurate view of ongoing cash flow.
4. Calculate Free Cash Flow (FCF): Free cash flow is defined as cash flow from operations, which adjusts for non-cash expenses and working capital changes, minus capital expenditures, which is the purchase of property and equipment. Free cash flow is a key metric for assessing the business’s capacity to support growth, meet debt obligations, or distribute dividends to shareholders. For succession planning, a positive FCF shows potential buyers or heirs that the business is financially sound. Many well known investors, such as Warren Buffett, are fond of businesses with high levels of stable free cash flow.
5. Forecast Future Cash Flow: Projecting future cash flow is a crucial step, as it informs the ability of the business to meet ongoing cash needs for funding growth, meeting debt obligations, or making distributions to equity holders. Using historical data, create a cash flow forecast that factors in both current trends and anticipated future expenses, like headcount growth, technology investments, pricing changes, or debt payments.
Using Cash Flow Analysis to Strengthen Succession Plans
Once a thorough cash flow analysis is complete, business owners can use this data to refine succession plans and identify strategies for a smooth transition.
1. Improve Financial Stability
The analysis may reveal cash shortages or volatility in the level of cash generation. By identifying these attributes early, business owners can take steps to stabilize finances, such as negotiating payment terms with vendors, cutting unnecessary expenses, reducing debt, or working with customers to land on more favorable payment terms. A business with stable cash flow is more appealing to buyers and easier to manage for successors.
2. Optimize for Valuation
Cash flow significantly impacts a business’s valuation. For small businesses, stable and predictable cash flow often increases valuation because it suggests lower risk. When cash flow is strong, it can result in higher offers from prospective buyers. In family-run businesses, strong cash flow enables more favorable terms for buyouts or inheritance planning, minimizing the next generation’s challenge when taking over the business.
3. Terms and Transaction Structure
Cash flow analysis can also help exiting owners determine the most viable payment structures for transferring ownership. For example, owners might choose an earnout agreement, where part of the purchase price is contingent on the business meeting specific cash flow targets. This approach provides reassurance to both buyer and seller, as it ties payments to the business’s financial performance. Seller financing is also common in small business acquisitions and represents a vote of confidence from the perspective of the new owner.
4. Plan for Contingencies
Cash flow analysis can help identify periods during which cash is forecasted to be tight, allowing the incoming owner to prepare for seasonal fluctuations or other cash shortages. For example, if the business typically experiences cash flow gaps in certain months, the owner can work with the successor to set up cash reserves or access to credit.
5. Transition Payroll and Operating Expenses
For many small businesses, payroll is a significant monthly expense. If the business will take on new employees as part of the succession plan, such as a new CEO or family members, cash flow analysis will reveal the company’s ability to support additional payroll expenses without straining resources.
Final Thoughts on Cash Flow Analysis and Succession
Cash flow analysis provides essential insight into a business’s financial position and helps owners make informed decisions for succession planning. For many small business owners, cash flow health can determine whether a business has a seamless handover, or struggles to execute a succession plan. By ensuring cash flow stability and forecasting future cash needs, owners pave the way for successful transitions that benefit both the new leadership and the legacy they leave behind.
Whether selling to an external buyer, passing the business to family, or planning a management buyout, small business owners should consider cash flow analysis a core part of their succession planning strategy. A sound understanding of cash flow ensures the business’s ongoing success and creates the financial foundation for future growth and sustainability.
