The earning capacity of a company is the primary driver of its value. Cash flow is the preferred measure of earning capacity for valuation purposes because it represents a purer form of earnings. Calculating cash flow begins with the net income or loss of a company then adjusting it for a number of items to achieve a figure that accurately portrays the true earning capacity of the company.

Depreciation involves writing off or expensing the cost of tangible assets like buildings and equipment over their useful lives. Amortization involves the same process for intangible assets like franchise fees and liquor licenses. Depreciation and amortization expenses are the result of accounting entries where no cash was actually spent, so they must be added back to net income to determine cash flow.

Income or expenses that are unusual or not likely to recur, distort the cash flow for that year. These items should be added back to (expense) or deducted from (income) net income. Some examples of non-recurring items are: the gain or loss on the sale of equipment, fines or penalties, writing off a large bad debt, or a major theft or casualty loss. Some unusual events may be due the cumulative effects of an ongoing situation. In these cases the income or expense should be allocated over the affected period.

The true earning capacity of a company needs to reflect adequate compensation to the owner for the services rendered to the company. The compensation of the owner should be based on the job market in its market area for similar positions. Small business owners wear so many hats that it is impossible to find jobs that will closely match what the owner does. Reasonable compensation can be estimated by taking the salary of managers within the same industry and adding a premium for all the extra duties of an owner. Another method is to use industry statistics that report the compensation of owners as a percentage of annual sales.

What you do with the estimated reasonable compensation figure depends on how your company operates. Since sole proprietorships and partnerships do not deduct owner compensation, the net income of the company should be reduced by the estimated reasonable compensation to determine earning capacity. The compensation actually paid to the owner of a corporation should be compared to the estimated reasonable compensation and the net income should be adjusted accordingly.

Closely held corporations often rent their real estate from the same person who owns the corporation. In these cases the rent paid should be adjusted, if necessary, to reflect market rates for similar properties in that area.

Expenses that are not necessary for normal business operations and are incurred at the discretion of, or for the primary benefit of the owner are called discretionary expenses. These expenses should be added back to net income to determine the true earning capacity of the company. Some common discretionary expenses are: expenses for the vehicle operated by the owner primarily for personal purposes, travel and entertainment, and charitable contributions. Some owners inflate the cash flow of their companies by overstating the amount of discretionary expenses, so these items should be kept to a minimum, reasonable, and easy to justify.

Valuation is based on the hypothetical sale of a company. The sales of most small companies include the operating assets of the company free and clear of all liabilities. Therefore the current debt of the company is not relevant to the valuation, so interest expense is added back to net income.

Adjustments to net income must be made carefully because they have such a direct impact on the earning capacity and value of a company. Most business owners have little accounting knowledge, so they often make incorrect adjustments. Here are some common errors.

Sole proprietors cannot add back their compensation because their compensation was not deducted as an expense. The amount taken out or withdrawn by the owner was not deducted as compensation. Payments on loans for personal items like vehicles cannot be added back because the principal portion was not deducted as an expense and the interest portion was added back previously. A good rule is to make sure that the items you are adding back were actually deducted in the first place.

Adjusting the net income or loss of a company for the items described above produces a cash flow figure that represents a much more accurate picture of the earning capacity of a company. Since the earning capacity of a company is the primary driver of its value, you now have a key piece of the valuation puzzle.