Why Cash Flow Is More Important Than Revenue When Buying a Company

A $5M company and a $1M company both might be for sale at 6x EBITDA, and you don’t need a spreadsheet, merely your fingers, to know a $5M price tag is out of your reach. The bigger company still is throwing a lot of cash around, more than you’ll ever see in one place, but much less hits the common till after the mortgage, payroll, and yourself are all paid off.

Why Revenue is a Vanity Metric

Revenue gives you information about the total sales of a company, but it does not indicate the profitability of the business.

A company can have high revenue numbers and still be unprofitable due to high costs such as production, rent, employees, and debts. In fact, 82% of small businesses that go out of business do so because of cash flow problems, despite having a solid revenue stream (U.S. Bank). This is not only relevant to owners but also to potential buyers who are looking to acquire businesses and are unaware of the real financial situation.

As a prospective buyer, what you really need to know is how much money is left after all the expenses have been paid. This is the money that will be used to pay off your acquisition loan. Revenue cannot do that. Profit margins can.

The Lender’s Lens: Ability to Repay

The lender couldn’t care less if the acquisition naturally grows or remains stagnant. They only care whether the business creates enough cash to pay them back. The metric they use is the Debt Service Coverage Ratio, DSCR. A typical lender wants to see a DSCR of at least 1.25, meaning the business generates $1.25 in cash for every $1 of debt it needs to service. Fall below that threshold and the deal doesn’t get done, regardless of how impressive the revenue looks on a pitch deck.

This is where SBA loans for business acquisition enter the picture. These government-backed loans are structured specifically to bridge the gap between a buyer’s down payment and the full purchase price, but approval still hinges on documented cash flow history. Projected growth doesn’t satisfy underwriting. Actual, verified earnings do.

The Add-Back Conversation

Small business owners often conflate the money their company makes with how much money they make. That might be accurate for tax implications, but it’s terrible if you are planning to one day sell your business. Basically, your tax return and your cash flow statement aren’t the same document.

Tax returns are, by necessity, a complete document of personal and business finances. The cost of a business lunch can end up on your business return, even though it did nothing to improve the company’s profitability. Cash flow, however, only tracks the finances of the firm. It won’t show a profit and a wife’s salary or a husband’s new truck on the plus side, so why would it on the downside?

That’s also true of anything else you pay with pre-tax business cash, like the boat you’ve convinced yourself is an essential part of your bed and breakfast’s appeal. Like vacation homes, those big-ticket items can subtract hundreds of thousands of dollars from your business’s assessed value if you’re the one accustomed to that sweet sweet write-off.

These items are typically part of Seller’s Discretionary Earnings, which are the business revenues available to pay your personal expenses and down-on-the-farm costs of living, as the buyer would have to devote in your stead. Beefing up a Seller’s Discretionary Earnings by putting everything under the sun on the business is an excellent way to get a prospective buyer not to take over that cost.

The Timing Trap That Catches Buyers Off Guard

One aspect of business that is often overlooked is that a sudden increase in revenue can lead to a shortage of cash. This is because when a company secures new contracts, it must invest money before receiving any in return, for example, to purchase stock, hire employees, or finance production. While accounts receivable may increase, the actual bank balance may decrease. In other words, a company may be “growing” in terms of revenue but “shrinking” in terms of operational cash.

This is also important to potential buyers because the working capital that remains in the company following the completion of a sale will determine whether you can continue to operate the business starting from day one. For this reason, many purchase agreements establish a working capital threshold, which represents the minimum amount of cash and assets that can be quickly converted into cash that a company needs to function normally without requiring additional capital. If you ignore this concept, you might end up finalizing the acquisition of a company only to realize that you are immediately short on funds.

What a Safe Acquisition Actually Looks Like

A company making $1 million in revenue with 20% margins may look a lot smaller than a $5 million revenue company with 2% margins, but it creates the same value for the entrepreneur. $200,000 per year in your pocket. The numbers are identical.

In a landscape full of tire kickers chasing massive revenue figures, you have to train your brain to ignore the top-line numbers and focus instead on the two or three entries below them, asking for those figures specifically if they aren’t shared up front. For all the sizzle we put on EBITDA multiples and revenue size in this industry, the only thing that matters is that number on the last line of your tax return each year. It’s the margin after the dust settles. Cash in the bank.