As a business owner in the lower middle market (those with sales between $2 million and $25 million), you’re probably familiar with business valuations. Perhaps you have them conducted annually to help identify both operational deficiencies as well as opportunities. Or maybe you’re interested in selling your company and want to find out your market value.
During the valuation process, your team of advisors will use various financial metrics to come up with an accurate value for your business. One of the metrics they’re likely to use is Earnings Before Interest, Taxes, Depreciation, and Amortization — more commonly known by the acronym EBITDA.
Still, you might be wondering, “What is EBITDA, exactly?” This article will explain what this metric is, what each component of EBITDA represents, and the important role it plays in the selling process.
What Is EBITDA?
EBITDA is a financial metric used to determine the value of a business by approximating pre-tax earnings from the company’s operations. The metric is not formally accepted under the Generally Accepted Accounting Principles (GAAP), which are accounting standards set forth by the Financial Accounting Foundation.
However, EBITDA is one of the most widely-used metrics during business valuations, as it provides a measure of a company’s operating cash flow.
Your advisor may use one of two EBITDA formulas, though both will bring you to the same conclusion:
- EBITDA = Operating Income + Depreciation + Amortization
- EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
In these equations, Operating Income simply measures Net Profit + Interest + Taxes. Net Profit is equal to Total Revenue minus Total Expenses.
What Are the Various Components of EBITDA?
As mentioned, EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” Understanding each component can give you a better grasp of your advisor’s valuation. These components include:
- Earnings: This represents the amount of profit remaining after you subtract expenses like the cost of goods sold. Earnings is also commonly referred to as Net Income.
- Interest: These are the financing costs associated with business debts. Essentially, interest payments are the costs that come with financing or borrowing money. When someone buys a business, it usually changes the capital structure of the company. The amount of interest expense is a function of how much debt a business has, and that will be different for the new owner.
- Taxes: Your business has both state and federal income tax expenses. The tax structure of the business may change under new ownership.
- Depreciation: This is a non-cash expense used to calculate the cost of a tangible asset over its useful life. It’s taken through accounting practices and is not an operating expense. Depreciation is sometimes used as a proxy or placeholder for capital expenditures (CAPEX). By doing this, your advisor is able to incorporate CAPEX into the earning power of the business.
- Amortization: This is similar to depreciation expenses, except it refers to loans or intangible assets like intellectual property and Goodwill.
Interest, Taxes, Depreciation, and Amortization are all “non-operational” expenses. This means they are not used for operating activities. By removing these from the equation, advisors can use EBITDA to garner a better understanding of a company’s profitability.
Lastly, it’s worth noting that the depreciation and amortization schedules that you’re currently using may change under new ownership. This is why your advisor removes them from the equation when determining earnings.
Why Is EBITDA Important?
EBITDA is important because it allows for a more accurate reflection of Operating Income. When determining EBITDA, your advisors will remove extraneous factors to get a clearer picture of your true cash flow from operations.
Extraneous expenses can include things such as tax rates, intangible assets, capital expenditures, and interest expenses. Many of these things are out of your control as a business owner and therefore don’t accurately represent the true financial health of your company. By removing these expenditures, advisors can determine your company’s operational efficiency.
Buyers also care about EBITDA as it allows them to see the operating profit of a prospective purchase. Using EBITDA allows buyers to see how much money they will have available post-sale to pay themselves, service debt, and invest in the company moving forward.
Furthermore, because EBITDA removes extraneous expenses, it allows advisors to make a more accurate comparison between different companies in similar industries. Again, by removing non-operating expenses, which are often out of a business’s control, advisors can measure the health of a company compared to its competitors based on its operating cash flow.
What Can EBITDA Teach Buyers and Sellers During the Selling Process?
EBITDA calculations are beneficial for both buyers and sellers during the merger and acquisition process. Buyers can use the metric to see a company’s cash flow from operations, which in turn can help them estimate future profitability.
The same can be said for sellers. EBITDA allows sellers to see their company’s ability to generate cash from assets and operations. Knowing this can allow them to make strategic future business decisions.
EBITDA valuations also show owners how they compare to other companies in the industry. If a seller’s earnings are less than the industry standard, they may need to make strategic decisions to build value — or, at the very least, dig into why their company’s earnings are below the industry standard.
A good understanding of EBITDA can also prevent valuation gaps. A valuation gap occurs when a seller believes their business is worth more than it actually is on the market. Valuation gaps can bog down or completely derail sales. Knowing a company’s EBITDA and true market value gives sellers reasonable expectations going into a sale.
Are There Any Other Versions of EBIT That Advisors May Use?
When conducting a business valuation, your advisor may use a variety of methods to accurately determine what your company is worth. They’ll analyze your financial statements – including income statements, balance sheets, and cash flow statements – and will apply multipliers based on the type of industry you’re in.
Your advisor may use a few different versions of EBITDA to conduct their valuation. Examples include:
- Basic EBIT (Earnings Before Interest and Taxes): This reflects the value of earnings without interest and taxes, though it does still consider depreciation and amortization expenses. EBIT reveals the accrual basis of operations and is often used in capital-intensive businesses.
- Adjusted EBITDA: Adjusted EBITDA takes a company’s EBITDA valuation one step further and removes expenses like one-time professional fees, startup costs, restructuring costs, or non-standard repairs and maintenance. These are all one-off expenses that do not occur frequently.
- EBITDAR (Earnings Before Interest, Tax, Depreciation, Amortization, and Restructuring/Rent Costs): This is similar to adjusted EBITDA in that it removes costs associated with rent or restructuring. This may be used in asset sales, as buyers may not be particularly interested in extending leases on, say, office space that has been rented. Removing these costs allows buyers to measure a company’s operating performance based on its assets.
The EBITDA used will depend on the type of industry you’re in and the type of business you run. This is one of the reasons why it’s crucial to have a trusted team of advisors handling your valuation. An experienced team can analyze your company’s financial performance and apply the multiple that best measures your operating profitability compared to other businesses in your industry. An accurate valuation is important, as it’s the starting point of a successful sale.
Use EBITDA to Measure True Cash Flow
What is EBITDA? In a nutshell, it’s a key financial metric used during the selling process. EBITDA allows both buyers and sellers to see a company’s operating profitability compared to similar businesses in their industry. In essence, it allows both parties to see how much cash a business generates from regular business operations.
If you’re preparing to sell your business, make sure that your valuation is accurate as it can help a business sale go smoothly. Learn more about the advisors at Allan Taylor & Company and see how an experienced team can help you with the merger and acquisition process.