What Is Discretionary Cash Flow?
Discretionary cash flow is the money left over once all capital projects with positive net present values have been funded, and required payments have been made. The payments can be operational costs, such as wages. The discretionary cash flow–or money left over–can be used to pay cash dividends to stockholders, bonuses to employees, buy back common stock, and pay down outstanding debt. Discretionary cash flow is a helpful metric since it can be used to assign a value on a business when buying or selling it.
- Discretionary cash flow is the money left over once all capital projects have been funded, and required payments, such as wages have been made.
- The discretionary cash flow is used to pay cash dividends, bonuses to employees, buy back common stock, and pay down debt.
- Discretionary cash flow is a helpful metric since it can be used to assign a value on a business when buying or selling it.
Understanding Discretionary Cash Flow
How discretionary cash flow is distributed is the responsibility of management. The way these funds are allocated can have a significant influence on the performance of the company. How discretionary cash flow is distributed also acts as a gauge for how well a company is being managed.
Discretionary cash flow is not a measurement of profit and loss and differs from the income that's reported come tax time. More precisely, discretionary cash flow may be viewed as the total benefit received by the owner of a business regardless of how they extract money from the business. Essentially, it shows how well a company produces cash on a regular basis.
Since discretionary cash flow shows the amount of revenue remaining after projects and operational costs are paid for, an increase over several periods can show a positive cash-flow trend. Conversely, if the cash flow is in a declining trend, it could mean the company is experiencing financial difficulties. However, a company with declining cash flow might merely be investing in capital-intensive projects designed to boost earnings growth in the long term. As a result, there is a fair mount ambiguity and subjectivity when analyzing discretionary cash flow.
Discretionary cash flow is also helpful by shedding light on a company's spending patterns. After all, many businesses may expend capital on things not at all related to or necessary for its operations–such as cars for family members or retreats for executives.
Discretionary Cash Flow when Buying and Selling a Company
Discretionary cash flow is also used in valuing a business for both the buyer and seller. A buyer would want to know a company's discretionary cash being generated because that revenue stream would be the buyer's investment return.
Conversely, the seller of a company would use discretionary cash flow in formulating a selling price for the business help in its valuation. A company with a higher discretionary cash flow, for example, would likely fetch a higher asking price than a similar company in the same industry that produces less discretionary cash flow.
As a result, discretionary cash flow can be referred to as "seller's discretionary income" or "buyer's discretionary income"–depending on who is performing the calculation.
How Discretionary Cash Flow is Calculated
- Begin with a business's pre-tax earnings
- Add to pre-tax earnings all its non-operating expenses and deduct non-operating income
- Add non-recurring expenses and deduct one-time (non-recurring) income (such as from the sale of assets)
- Add in depreciation and amortization costs
- Add in interest costs and deduct interest income
- Add in the total compensation paid to the business's owner
- Adjust to market value any compensation to other owners of the business (meaning, subtract the sum the business would have to pay an employee to get the same services as those provided by the owner)
Buyers and sellers who perform a discretionary cash flow calculation may come up with significantly different values for the very same business. For example, a buyer and a seller may not see eye to eye on what constitutes a one-time expense. A seller and a buyer may also have vastly different plans on how much labor they will contribute to the operations of a business, which may lead to significant labor cost differences.